Risk

Posted on by Devesh Deepak Bonds, Investment, Macro-economy, Yield Curve

Yield Curve Primer

A yield curve is a graphical representation of the current interest rates. The interest rate varies across the maturity.  The yield curve shows the rate of return that can be locked in now for various terms into the future. The left, vertical Y-axis of the graph shows the YTM that is currently available in the marketplace. The bottom, horizontal X-axis shows the G-Sec maturity. The yield curve is the line connecting YTM across maturities and looks something like this:

YTM000

A yield curve can be created for any specific segment of the bond market, from AAA-rated corporate bonds to single-B rated corporate bonds. The G-sec yield curve is the most widely used because G-Sec has no perceived credit risk, which would influence yield levels, and G-sec and T-bill market includes securities of every maturity, from 3 months to 40 years.

As the investor in the Bond, we all know that Yield to maturity reflects the total return an investor receives by holding the bond until it matures. But why the yield curve is important and does it has a predictable power?

The information contains in the yield curve is valuable for the prediction of business cycles, inflation, and monetary policy; the response of the yield curve helps to understand the extent of transmission of monetary policy and, it is also the barometer to measure the impact of any surprises on the macro economy. The importance of Yield curve can also be gauged by the fact that it represents the relationship among short, medium and long-term yield and most of the pricing activity taking place in the bond markets centres around it. The Yield curve is also called Term Structure of Interest Rates. To understand the shape of the yield curve, we must understand the variables of yield curve – level, slope, and curvature.

Level = Average yield of Short Term (3mnths), Medium Term (2years) and Long Term (10years).

Slope = Spread = Difference in the yield of Short Term (3mnths) and Long Term (10years).

Curvature = [2 x Long Term yield (10years) – Short Term yield (3mnths) – Medium Term yield (2years)].

And examine the theories and hypotheses that explain the yield curve and the relationship of short, medium and long-term interest rates:

  • Pure expectations: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk.
  • Liquidity premium: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk, plus a premium for holding long-term bonds, called the term premium or the liquidity premium.
  • Preferred habitat: In addition to pure expectations and liquidity premiums, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their “preferred” maturity, or habitat.
  • Market Segmentation: postulates that the yield curve is determined by supply and demand for debt instruments of different maturities.

The Yield curve has five major characteristics:

  • The change in yields of different term bonds tends to move in the same direction.
  • The yields on short-term bonds are more volatile than long-term bonds.
  • The Long-term yields follow the short-term yields.
  • The yields on long-term bonds tend to be higher than short-term bonds.
  • At a given level, yields are mean reverting.

The pure expectations hypothesis explains the first three characteristics; the liquidity premium theory explains the fourth characteristic and the market segmentation explains the last one.

The Shape of the Yield Curve

There is a dynamic relationship between fiscal and monetary developments – government debt and the budget deficit, real output, inflation and the monetary policy rate– and the shape of the yield curves.

Normal Curve

A normal, upward-sloping yield curve suggests the economy will grow in the future, and this may lead to higher inflation and higher interest rates. No one will buy longer-term securities without a higher interest rate than those offered by shorter-term securities. A normal yield reflects the easing of monetary policy and easy liquidity. And the economy expected to expand. The upward sloping normal yield curve is the most common shape of the yield curve.

YTM002

Inverted Curve

When the long-term yields fall below short-term yields, the yield curve becomes inverted. An inverted yield curve indicates the economy is to slow or decline in the future and this slower growth may lead to lower inflation and lower interest rates across all maturities. An inverted yield curve typically indicates that central banks are ‘tightening’ monetary policy, limiting the supply of money in the banking system and thus control credit availability. An inverted yield curve has indicated, in the past, the slowing down of economic growth and even recession.

YTM001

Flat Curve

When the short-term bond yields increases and yields on long-term bonds decrease, the yield curve flattens or appears less steep. A flattening yield curve can indicate that expectations for future inflation are falling and thus the demand higher long-term bonds fall. Since inflation is less of a concern, the long-term premium shrinks. A flat yield curve indicates a slower economic growth.

YTM004

Humped Curve

A humped yield curve is a kind of flat yield curve or reflects uncertainty about specific economic policies or conditions, or it may reflect a transition of the yield curve from a normal to inverted or vice versa.

YTM003

Posted on by TeamGenus Asset Allocation, Investment, Mutual Fund, Risk

White Paper – Investment Plan

One of the parts of developing a comprehensive financial plan is the development of an investment plan. Investment Planning is the process of finding the right mix of investment option based on your future goals, time horizon, and risk profile. There are six steps that you should follow when you are developing your investment plan.

The Means to Invest

In order to even begin this portion of your financial plan, you must determine that you are ready to invest. In this step, you will determine if you are going to use the money for some good or service (spend it), or if you will invest or save the money.

Investment Time Horizon

In this step, you will be determining how long you plan to invest and when you will need the funds to meet your financial objective(s). You must decide, based on the time horizon of your objectives, among short-term investments, long-term investments or some combination. In this step, you are going to be determining what you will be saving for, which should give some indication of your time horizon.

Risk and Return

You will need to determine what your level of risk tolerance is. As the level of risk tolerance increases so does the potential for higher returns as well as larger losses.

Investment Selection

Based on 1, 2 and 3 above, investments should be selected to meet your goals. These investments must satisfy your time horizon and your risk tolerance.

Evaluate Performance

Once investments are chosen and expectations are established, the performance of your investments should be determined by comparing the actual realized returns against the expected returns. The returns should also be compared to a benchmark, such as the Sensex or Nifty index. In addition, the investments should be reevaluated to determine if they continue to meet your investment criteria.

Adjust Your Portfolio

Your portfolio should be adjusted to maintain your goals and your investment criteria. If your goals change, your investments should be reviewed to determine if they continue to meet your objectives.

Benefits of Investment Planning

 Investment planning helps you:

  • Generate income and/or capital gains.
  • Enhance your future wealth.
  • Strengthen your investment portfolio.
  • Save on taxes.

Investment Strategies – Passive vs. Active Strategy

Passive

Passive strategies do not seek to outperform the market but simply to do as well as the market. The emphasis is on minimizing transaction costs and time spent in managing the portfolio because any expected benefits from active trading or analysis are likely to be less than the costs. Passive investors act as if the market is efficient and accept the consensus estimates of return and risk, accepting the current market price as the best estimate of a security’s value.

A buy-and-hold strategy means exactly that – an investor buys fund or stock and basically holds them until some future time in order to meet some objective. The emphasis is on avoiding transaction costs, additional search costs, and so forth. The investor believes that such a strategy will, over some period of time, produce results as good as alternatives that require active management whereby some securities are deemed not satisfactory, sold, and replaced with other securities. These alternatives incur transaction costs and involve inevitable mistakes.

Active

An active strategy involves shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better and avoid or de-emphasize those sectors that are expected to do relatively worse. Investors employing this strategy are betting that particular sectors will repeat their price performance relative to the current phase of the business and credit cycle.

Most of the Mutual funds in India are actively managed. The goal of active management is to beat a particular benchmark. Because the markets are inefficient, the anomalies and irregularities in the capital markets are exploited by the active fund manager. Prices react to information slowly enough to allow skillful investors to systematically outperform the market.

Building an Investment Portfolio

Asset Allocation

Investors often consider the investment decision as consisting of two steps:

  1. Asset allocation
  2. Fund selection

The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in other words, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, money market assets, and so forth. Each weight can range from zero percent to 100 percent.

The asset allocation decision may be the most important decision made by an investor.

The rationale behind this approach is that different asset classes offer various potential returns and various levels of risk, and the correlation coefficients may be quite low.

Portfolio construction involves the selection of securities or mutual funds to be included in the portfolio and the determination of portfolio weights. The Modern Portfolio theory provides the basis for a scientific portfolio construction that results in efficient portfolios. An efficient portfolio is one with the highest level of expected return for a given level of risk or the lowest risk for a given level of expected return.

Asset Classes

Portfolio construction begins with the basic building blocks of asset classes, which are the following major categories of investments:

  • Cash (or cash equivalents such as money market funds)
  • Stocks
  • Bonds
  • Real Estate (including Real Estate AIF)
  • Commodity, bullion or others

Each investor must determine which of these major categories of investments is suitable for him/her. The next step is to determine which percentage of total investable assets should be allocated to each category deemed appropriate.

Risk Reduction in the Portfolio

Diversification

One has to remember that no investment is Risk-free. Every investment has the potential gain as well as losses. The diversification is not a guarantee against any potential loss. Based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.

A diversified portfolio is built by a judicious mix of assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction, and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio, hopefully, is growing. The intention of using this strategy is that the loss incurred due to the negative performance of a particular asset class is partially or wholly offset by gains via the positive performance of another asset class. Another important aspect of building a well-diversified portfolio is that you try to stay diversified within each type of investment.

Modern Portfolio Theory

Covariance is a measure of the co-movements between securities returns used in the calculation of portfolio risk. We could analyze how security returns move together by considering the correlation coefficient, a measure of association learned in statistics.

As used in portfolio theory, the correlation coefficient is a statistical measure of the relative co-movements between security returns. It measures the extent to which the returns on any two securities are related; however, it denotes only association, not causation. It is a relative measure of association that is bounded by +1.0 and -1.0, with

Pi,j = +1.0, perfect positive correlation

Pi,j = -1.0, perfect negative (inverse) correlation

Pi,j = 0.0, zero correlation

With perfect positive correlation, the returns have a perfect direct linear relationship. Knowing what the return on one security will do allows an investor to forecast perfectly what the other will do.

With perfect negative correlation, the securities’ returns have a perfect inverse linear relationship to each other.

With zero correlation, there is no relationship between the returns on the two securities. Knowledge of the return on one security is of no value in predicting the return of the second security.

Rupee Cost Averaging

The systematic investment with mutual funds, along with consistent periodic new purchases of the mutual fund, creates risk reduction by creating a lower cost per unit owned over time. This is known as rupee cost averaging. This strategy allows one to take away the guesswork of trying to time the market. You invest a fixed amount of money at a regular interval, regardless of whether the market is high or low. By doing so, you buy fewer units when the prices are high and more units when the prices are low. Because rupee cost averaging involves regular investments during periods of fluctuating prices, you should consider your financial ability to continue investing when price levels are low. However, this approach reduces the effects of market fluctuation on the average price you pay for your shares. Additionally, it helps you maintain a regular investing plan.

Conclusion

Even the best-laid investment plan will fail if you can’t control your behaviour.  That’s one of the biggest reasons for keeping your disciplined investment strategy as simple as possible.

It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend.  And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.

There is enough statistical evidence to suggest that if you invest regularly for a long term, your money will grow on a consistent basis.

References

  1. Investments: Analysis and Management by  Charles P. Jones

  2. US SEC
Posted on by Devesh Deepak Equity, Hedge Fund, Long-Short strategy

Why to Invest in Hedge Funds

“Higher the risk, higher the return; lower the risk, lower the Return”. This is the first concept of Investment you come across whether you are a seasoned investor or a newbie while talking to any adviser or participating in any investors’ education programme.

For many years, investors have been told that risk and return are correlated. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return trade-off is the balance between the desire for the lowest possible risk and the highest possible return. This whole idea is graphically illustrated here and we are sure each one of us must have seen this graph at least once in our lifetime.

risk-return

This graph depicts the idea beautifully but there is one flaw. The Risk-Return trade-off line is not a straight line in real life. That is, the return per unit of risk is not constant. More risk will not necessarily bring you more return and the return per unit of risk start diminishing as you take more and more risk. This is the second concept of Investment called Law of Diminishing Marginal Utility.

‘Utility’ is a term used in economics to describe how much value or happiness one derives from a good or service. Marginal utility refers to how much additional value/happiness is derived from one additional unit of the good or service. Most goods and services are said to have “diminishing marginal utility.”

‘Diminishing marginal utility‘ can be understood by this simple example – If you are hungry, you will relish your first dosa, you may eat your second dosa but very few of us will enjoy the third one. As our hunger satiates after the first one, our urge to eat another dosa diminishes though the taste of each dosa is the same.

More risk can’t generate a proportionate higher return and it’s a fact of life that markets fluctuate and unpredictable. But occasionally markets experience bouts of extreme volatility and declines, which can wreak havoc on portfolios. Statistics over the last 20 years show 5% pullbacks typically happen about two to three times a year, 10% to 15% corrections every one to two years and 20% bear drops every three to five years and over 50% once in a decade.

It’s easy to ride out small fluctuations given a long time horizon. But with rare large declines, most investors get perturbed by the mark to market loss and allow the behaviour aspect rode over the fundamental aspect of investment. It would be better having a bit of protection or hedge — either for peace of mind or for performance. This concept of Investment is called Hedging, which can be achieved by buying derivative to protect your long position. This cost reduces your return in an up swinging market but protect you from draw downs and generate better risk adjusted return.

Hedging risk has been an integral part of the financial markets for centuries. One of the more notable early successes came in the 17th Century when commodity producers and merchants devised a way to protect themselves against unfavorable price changes through a system of ‘forward contracts’.

Another aspect of hedging is Arbitrage. Arbitrage is a strategy where you try to capture the price difference of stock, commodity, etc in two different markets by buying in one and selling in another simultaneously. This is a market neutral strategy and you are not concern about the market direction. In India, you profit by exploiting the price differences by buying in the cash market and selling in the future market. Subsequently, you square up the trade on or before the expiry of future contract to realise the gain.

The term ‘hedge fund‘, however, dates back only to 1949. At that time, almost all investment strategies took only long positions. Alfred Winslow Jones, a reporter for Fortune, published an article arguing that investors could achieve far better returns if hedging became an integral part of an investment strategy. Jones launched a small investment partnership to test his belief. He incorporated two investment tools into his strategy – short selling and leverage – to simultaneously limit market risk and magnify returns.

As an Indian, we have historically invested in long-only strategies, be it Stocks, Mutual funds, PMS or Insurance. Since the naked short sale is not permitted in any of these investment avenues, we never benefited like global investors and fund managers who take advantage of mispricing, overvaluation, and euphoria in the markets to make investment returns by shorting a stock. This strategy yields sizable returns in bearish markets, where the share prices take a plunge.

A long-short strategy is used primarily by hedge funds, seek to deliver positive returns with low correlation to equity markets by taking long positions in stocks whose prices are expected to rise and short positions in stocks that are expected to decline.

The fund manager take a long position in a stock by buying it: If the stock price rises, the fund will make money. For shorting a stock, fund either uses the derivatives or borrows the stock they don’t own, sell it and then hoping it declines in value and then buy it back at a lower price and return the borrowed shares.

The Indian equity market is more volatile than US, European and other major Asian markets. Higher Volatility in the market couple with Lower Correlation and Higher Dispersion among Indian stocks provides an opportunity to generate alpha through active management of long and short positions.

Hedge funds profit from winners and losers both by taking long positions in winning stocks and short positions in losing stocks; it reduces the volatility and limits max draw down.

Structure of Hedge Funds in India

Hedge Funds in India are category III Alternative Investment Fund governs by SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”).

Alternative Investment Fund or AIF are privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.

Specific exclusions include family trusts, employee stock option trusts, employee welfare trusts or gratuity trusts, holding companies, special purpose vehicles not established by fund managers and regulated under a specific regulatory framework (eg. securitization trusts), and funds managed by registered securitisation or reconstruction companies.

An AIF under the SEBI (Alternative Investment Funds) Regulations, 2012 can be established or incorporated in the form of a trust or a company or a limited liability partnership or a body corporate. Most of the AIFs registered with SEBI are in trust form.

Category I AIFs

AIFs which invest in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such other Alternative Investment Funds as may be specified.

“Angel fund” is a sub-category of Venture Capital Fund under Category I Alternative Investment Fund that raises funds from angel investors and invests in accordance with the provisions of AIF Regulations.

Category II AIFs

AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Various types of funds such as real estate funds, private equity funds (PE funds), funds for distressed assets, etc. are registered as Category II AIFs.

Category III AIFs

AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Various types of funds such as hedge funds, PIPE Funds, etc. are registered as Category III AIFs.

There is no exact definition for the term “Hedge Fund”; but it is generally accepted that any investment fund that used incentive fees, short selling, and leverage are hedge funds. However, there are many category III AIF which are not utilizing the hedging and arbitrage strategies and are engage in relatively traditional, long-only strategies.

The eligibility criteria and conditions for Hedge funds in India are:

  • Investors can be Indian, NRI or foreign.
  • Only spouse, parents and children can be a joint investor.
  • Minimum corpus should be Rs. 20 Crores for each scheme.
  • Minimum investment by each investor should be Rs. 1 Crore.
  • The Maximum number of investors can be 1000 for each scheme.
  • Category III AIFs can be both open and close ended.
  • The manager or sponsor shall have a continuing interest in the respective AIF, (a) of not less than 5% of the corpus (in Category III), or (b) Rs. 10 Crores (for each scheme) whichever is lower.
  • Leverage of a Category III AIF cannot exceed 2 times the NAV of the fund.
  • Units of close-ended AIFs may be listed on stock exchange, subject to a minimum tradable lot of Rs. 1 Crore and such listing of AIF is permitted only after the final close of the fund or scheme.

Reference

  1. AIF Regulation
  2. AIF FAQ
  3. Registered AIF
  4. The Indian Association of Alternative Investment Funds (IAAIF)
Posted on by Devesh Deepak Bonds, Mutual Fund, Risk

Deciphering Bond – 2

In a country like ours, the bank fixed deposits and government sponsored products like Tax-free bonds, PPF and Post office schemes created an illusion that Debt is risk-free. This is a bit surprising because there were numerous defaults in NBFC FDs, Company deposits, RNBC deposits and chit funds in last two-to-three decades but every such default only strengthens the views that the government sponsored product are high in security and returns and what’s the need to invest in other debt products.

There is another counter view which is gradually catching the imagination of investor is Debt mutual fund. The AUM (Asset under management) of Debt schemes in the Mutual fund industry stands at over Rupees Ten lakh crore as on September 30, 2016. Often there is a great deal of discernment about an investment avenue that brings clueless investors down the wrong path. Investors also have such beliefs for Debt funds that could be partly true at best and misleading at worst. Here we will try to decipher risk associated with investment in Debt, which is equally true for debt mutual funds.

No market-related investment is risk-free, be it equity or debt. While debt funds are not as risky as equity funds, they are not without risks either.

The two prime risks in a debt instrument are the interest rate risk and credit risk.

Interest Rate Risk

Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds generally rises. Conversely, when interest rates rise, the price of bonds tends to fall.

Let’s assume you purchase a bond from Company ABC. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, call option, and other characteristics of the bond.

One common way to measure a bond’s interest rate risk is to calculate its duration.

In general, short-term bonds carry less interest rate risk; less responsive to unexpected interest rate changes than long-term bonds are. This implies that short-term bonds carry less interest rate risk than long-term bonds.

Credit/Default Risk

Credit risk is the likelihood that a bond issuer will not make the interest payments or principal repayment to its bond-holders. It means the issuer may default. All bonds, except for those issued by the government, carry some credit risk. This is one reason why corporate bonds almost always have a higher yield than government bonds.

While the definition of credit risk may be straight forward simple, measuring it is not.  Many factors, like a business loss, poor cash flows, change in business environment, country’s socio-political situation etc can influence an issuer’s credit risk and in varying degrees.

Rating agencies like CRISIL, ICRA, Moody’s and Standard & Poor’s analyse bond offerings in an effort to measure an issuer’s credit risk on a particular security. Their results are published as ratings that investors can track and compare with other issuers.

These ratings range from AAA (the most secure) to D, which means the issuer is already in default.

Rating downgrades generally come from rating agencies. A downgrade from any one of them is a major signal that an issuer is more likely to default on its debt. If a bond is downgraded to a level below investment grade (aka, “junk”), there is often a serious sell off of those bonds, because most institutional investors are forbidden from owning junk bonds.

Ratings have a large influence on the demand for a security. Downgrades (or even rumours of downgrades) tell investors that a security is now believed to be riskier, which may have a negative impact on the security’s price. In turn, downgrades often lead to less trading activity and lowered liquidity.

Other Risks

a) Reinvestment Risk

Reinvestment Risk is the likelihood that an investor won’t have the opportunities to reinvest income streams from the Bond at a rate equivalent to the Bond’s present rate of return

For example, consider a Company ABC bond with a 10% yield to maturity (YTM). In order for an investor to actually receive the expected yield to maturity, she must reinvest the interest payments she receives at a 10% rate. This is not always possible. If the investor could only reinvest at 8% (say, because market yield fell after the bonds were issued), the investor’s actual return on the bond investment would be lower than expected. This risk becomes more pronounced if issuer has the call option to retire the bond before the maturity.

b) Inflation Risk

Inflation risk also called purchasing power risk, is the likelihood that the returns from the Bond won’t be worth as much in the future on account of changes in purchasing power because of inflation.

For example, Rs.1,00,000 in bonds with a 10% coupon might generate enough interest payments for a retiree to live on, but with an annual 5% inflation rate, every Rs.10,000 produced by the portfolio will only be worth Rs.9,523 next year and about Rs.9,070 the year after that. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.

Inflation-indexed bonds were designed to provide a hedge against rising prices or inflation. They attempt to address this risk by adjusting their interest rate for inflation to prevent changes in purchasing power.

c) Liquidity Risk

Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction. Liquidity refers to how deep or liquid the market is for a particular security. If the market is deep, an investor can purchase or sell a security at current prices.

The risk that investors may experience issues finding a purchaser when they need to sell and might be compelled to sell at a significant rebate to market value. Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.

Posted on by Devesh Deepak Bonds, Risk

Deciphering Bond

In the annals of Investment folklore there is an old saying, if you want to make the most money, you should invest in stocks. But if you want to keep the money you made in stocks, you should invest in bonds.

We always consider Bonds as the most important asset class though it also has the lowest expected rate of return. Bonds are largely regarded as being lower-risk investments than shares, which is why they’re so popular with big institutions such as Banks, Provident Funds, Insurance and pension funds.

Bonds are important as they are a better indicator of wider macro signals and risk measures, rather than shares. Bonds and especially government securities tend to react very quickly to the macroeconomic signals and risk measures. Equity markets try to remain ahead of any earning and the economy uptrend; that is, they’re probably about six months ahead of any data indicating an economic recovery. Equities, in particular, can be very volatile and sometimes share prices are moved by factors that have nothing to do with interest, inflation or GDP growth rates, or economic/business cycles.

Basic Things to Know About Bonds

A bond is a type of investment that represents a loan between a borrower and a lender. With bonds, the issuer promises to make regular interest payments to the investor at a specified rate (the coupon rate) on the amount it has borrowed (the principal amount) until a specified date (the maturity date). Once the bond matures, the interest payments stop and the issuer is required to repay the face value of the principal to the investor.

Because the interest payments are made generally at set periods of time and are fairly predictable, bonds are often called fixed-income securities.

Maturity

The maturity date of a bond is the date when the principal or par amount of the bond will be paid to investors, and the company’s bond obligation will end.

Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years.

 Not all bonds reach maturity, even if you want them to. Callable bonds are common: They allow the issuer to retire a bond before it matures. Call provisions are outlined at the time of issuance of the bond itself.

Coupon

A bond’s coupon is the annual interest rate paid to the bondholder, generally paid out annually or semi-annually on individual bonds. The coupon is always tied to a bond’s face or par value and is quoted as a percentage of par values. It is also referred to as the coupon rate, coupon percent rate and nominal yield.

Bonds that don’t make regular interest payments are called zero-coupon bonds. As the name suggests, these are bonds that pay no coupon or interest. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the most commonly used yield measurement. The yield to maturity (YTM) is a very meaningful calculation that tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will receive (assuming you reinvest these interest payments at the same rate as the current yield on the bond), plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium) on the price of the bond. YTM is useful because it enables you to compare bonds with different maturity dates and coupon rates.

Coupon vs YTM

Fluctuations in interest rates usually have the biggest impact on the price of bonds – interest rates can be affected by many things, including a change in inflation rates. Generally speaking, bond prices move inversely to interest rates because the coupon rate usually remains constant through to maturity. If current interest rates are higher than the coupon rate, the bond is less attractive to investors and drops in value, since investors aren’t willing to pay as much for a series of lower coupon payments. Bond prices increase when the coupon rate is higher than current interest rate levels. To an investor who holds bonds through to maturity, price fluctuations may seem irrelevant.

Let us assume that a bond has a face value of Rs 100 with an 8% coupon rate. A coupon rate or nominal yield indicates that if you hold a bond from issuance to maturity, you are expected to receive the amount equal to the coupon rate every year and par value at maturity. This means that the investor will earn Rs 8 per annum on each bond he invests in.

Scenario1: Interest rates rise to 10%. Even so, the investor will continue to earn Rs 8 that is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 80.

Scenario2: Interest rates fall to 6%. Again, the investor will continue to earn Rs 8. This time the price of the bond will have to go up to Rs 133.

Duration

The maturity of the bond matters. The greater the maturity – the longer the life of the bond – the stronger the effect with regards to gains and losses is of interest rates in the economy.

To estimate how sensitive a particular bond’s price is to interest rate movements, the bond market uses a measure known as duration.

Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid.

If you know how to calculate the present value of the future cash flows, you will very well calculate the duration of the bonds. As an investor, it is good to know the calculation but it is better to understand the relationship among price, yield and modified duration of a bond.

            ΔP = – MD * ΔY

where,

Modified duration = Duration / (1 + yield)

P = Price

Y = yield

Let’s assume that modified duration of the bond is 3 years. So if the yield fell by 0.5%, the price would go up by 3 x 0.5% = 1.5%. If the yield rose by 0.5%, the price would fall by 1.5%.

Modified duration is a standard risk measure in bond fund management but it is important to remember that it is used only for small movements in yield.

Conclusion

Many people including legendary investor Warren Buffett has argued that bonds fail to protect investors’ purchasing power. When taxes and inflation are subtracted from bond returns, investors fail to gain wealth.

This is true if you hold your entire portfolio in cash or bonds, you run the risk of losing out to inflation. This is particularly a threat in the low-interest-rate environment. We don’t think bonds should be shunned. When held to maturity, bonds provide a consistent return of capital. Bonds also have low long-term correlations with stocks, making them a good diversifier. Bonds and shares are two important component of asset allocation and you can’t wish away any of them.

Posted on by Devesh Deepak Risk

Are we Loss averse or Variance averse?

How many times you have compromised on return and invested in a relatively safer instrument; or fretting about the potential loss before making an investment, or worst sold the investment whenever there was the slightest dip in the value of the portfolio. This impulse to protect you is called the safety first principle or “loss aversion.”

The influence of emotions on decision-making is widely accepted. Neurophysiology evidence suggests that loss aversion has its origins in relatively ancient neural circuitry (e.g., ventral striatum). This evidence also helps us to understand while modern finance theories tend to see risk as related to variance in expected returns; the psychology literature tends to link risk to probability or size of potential losses.

The assumption of modern portfolio theory about the efficiency of market and rationality of investor is long been nullified. Individuals do not tend to act rationally when making decisions in a risky environment. Most of the times individuals have little information, process such information using simplified routine, and are influenced by the way in which information are presented to make a decision.

Before the advent of Modern Portfolio theory (MPT), the investment risk is measured in terms of absolute loss or relative loss vis-à-vis of a market index. Variance as a measure of Risk was first introduced by Economist Harry Markowitz in MPT in a 1952 essay, for which he was later awarded a Nobel Prize in economics. This idea of variance as a measure of Risk is so new that it never percolated in the psyche of investors, despite the fact that all the subsequent development in Risk Management – Risk-adjusted return, Value at Risk, EWMA, Downside Deviation or GARCH – uses variance as a building block.

The significance of standard deviation (the square root of variance) can be gauged by the fact that 68.2% of the time your return of the investment will lie between one standard deviation above and one standard deviation below the mean value, 95.4% of the time your return of the investment will lie between ‘2’ standard deviation above and ‘2’ standard deviation below the mean value and 99.7% of the time your return of the investment will lie between ‘3’ standard deviation above and ‘3’ standard deviation below the mean value.

We don’t have empirical evidence to conclude whether individuals are loss averse or variance averse but our experience in the field of investment suggest that individual is more loss averse than variance averse.

Dan Ariely, James B. Duke Professor of Psychology and Behavioural Economics at Duke University, and the author of ‘Predictably Irrational’ and ‘The Upside of Irrationality’, both of which became New York Times bestsellers opined that “People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.”

The asymmetrical behaviour of the individual under the fear of losing money tends to make these common mistakes:

First, they ‘overweight’ the lesser probability and ‘underweight’ the higher probability and sometimes totally ignore a minor event.  Their response to a loss is more extreme than the response to a gain of the same magnitude. Instead of cutting loss, they try to recoup the loss by liquidating their profitable assets—that could run counter to their long-term investment goals.

Secondly, they often increase their risk-taking in order to try to escape losses and fall victim to the sunk-cost fallacy. The sunk-cost fallacy is behaving as if more investment alters your odds, believing the more you put in, the more it will pay off.

Third, they fail to distinguish between a bad decision and a bad outcome. Individual regrets bad outcome of a good company like a weak quarterly result or low returns over a period, even if they have chosen the investment for all the right reason. In such case, regret can lead them to make a decision to sell. This means selling at the bottom instead of buying more.

Lastly, they justify holding the safe investment by comparing the alternatives with respect to a specific point of time, that is, they always evoke Internet bubble of 2000 or Lehman Brothers collapse of 2007 to justify not investing in stocks – thus losing the chance of potential return.

It is interesting to note investors – amateurs and professionals alike, regardless of intelligence or skill level – act intuitively under risky and uncertain condition forgetting that today’s uncertainty won’t likely last forever.

Risk aversion is important. This is natural check and balance – keep us away from financial fraud and also keeps our expenses in control, and helps us to save for a rainy day. But loss aversion is short-sightedness. It happens when we lose sight of our long-term goals, and focus too much on short-term events.

Posted on by Devesh Deepak Risk

Risk: The four letter word

As an adviser, we were expected to educate the investor about the Risk of investing in the financial markets. In today’s environment of transparency, we assume that investors want to know the truth, so don’t hide it.  And hence we inundate them with the idea of Absolute and Relative risk, Systematic and Unsystematic risk, Default Risk, Geography Risk, Interest rate risk, Liquidity risk, and what not.

I totally understand why people talk like that. First, there’s an assumption that lettered person makes better adviser. Second, being able to talk like that makes adviser seasoned, someone who has gone through the rut and his idea is now chiseled out.

In reality most of the time these jargon-laden definition makes an investor more confused. It’s not that investor doesn’t understand the risk but not the way we convey it. This commonly used “four letter word” is the most abused word in the investing annals.  It may have totally different meanings for different individuals. To many investors, risk means the cost of making a mistake.  It could be financial, social, psychological, or even emotional. The risk is about fear of change.

Financial Experts judge risk in terms of quantitative assessments whereas most people’s perception of risk is far more complex, involving numerous psychological and cognitive processes. To assume people perceive risk pertaining to their life, family, career, and profession differently than their investment risk is a false assumption.

People tend to be intolerant of risks that they perceive as being uncontrollable, having catastrophic potential, having fatal consequences, or bearing an inequitable distribution of risks and benefits. Can we overcome this resistant by simply disseminating more and more information about the product and assets we are proposing? I don’t think more data supported by evidence of past and validated by external sources reduces the resistant.

In Investment industry, the assessment of Risk Tolerance of investors is either intuitive or based on risk profiling tools. Most risk profiling tools are based on psychometric test built in the nineties. Most tools are based on inadequate statistics, such as using historic volatility as the key metric for measuring risk and that could lead to “flawed outputs”. The probable consequence of inadequate or poor risk profiling is an investor making investments that are not suitable for their objectives, financial situation, and needs. The results of such a tool should only provide a starting point for a conversation about investment risk, not an ending.

In my last two decades of dealing with investors, I find equity is the most resisted asset class. Some investors find the volatility unnerving; while some dread the probability of absolute loss; some has bad experiences in the past; and some wants a regular income. As an adviser, one need to be persevering. One can’t do a risk profiling of an investor in a session or two. The true assessment of risk tolerance, capacity for loss assessment and a risk required analysis can be done over a period of time. Till such time your proposal should align with the risk perception of the investors.