ISME

Explore - Experience - Excel

Demystifying Bonds- Series II

  • 17 Oct
  • 2014
                                Demystifying Bonds- Series II
                                By Bikramaditya Ghosh, Asst. Professor              
Some situational strategies that are adopted by debt fund managers which I would like to elaborate here –

  1. Riding the Yield Curve – In a normal upward sloping yield curve, yield of a security rises as its maturity increases. Using this strategy, if a fund manager holds on to a bond of a higher maturity over a period of time, it’s yield would tend to fall as it comes down the yield curve (drops in maturity). Owing to the inverse relationship between yields and prices, the price of the bond would rise and help to earn returns via capital gains using this strategy.
  2. Riding the Spread Curve – Typically bonds with a higher credit risk command a higher yield as risk and yields are commensurate. Using this logic, corporate bonds command higher yields vis-a-vis government bonds of the same maturity. This difference in yields is called yield spreads or credit spreads. These spreads widen as the economy weakens and corporate bonds offer higher yields. In such a situation, investing in well researched corporate bonds may provide higher accrual yields. This is called riding the spread curve.
  3. Spread Compression – The opposite of the above happens when the economy improves and spreads (yields) decrease or compress. Owing to the inverse relation between yields and prices, the prices of these bonds rise and one stands to gain from capital appreciation via Spread Compression strategy.
  4. Rating Upgrade – Bond prices and credit ratings are directly co-related. Higher the rating, higher the price for same maturity bonds. This strategy revolves around buying a well-managed company’s bonds with a relatively lower credit rating. As the economy improves, the sales and profitability of this company also improves. This may lead to its rating being upgraded. One, who can gauge that a company’s fundamentals are going to change for the better, can lock into a higher yield first and also benefit from the price rise when the rating goes up. However, it needs a lot of research to identify such companies.
Now it could be seen how Bond Price reacts to Inflation Rate (discounting Factor)

Inflation Rate
9%
11%GS2029
Base Year for Calculation is 2014
Face Value 100
Year
No. Of Years
Coupon
DCF
WDCF
2014
1
11
10.09174

10.09174
2015
2
11
9.25848
18.51696
2016
3
11
8.494018
25.48205
2017
4
11
7.792677
31.17071
2018
5
11
7.149245
35.74623
2019
6
11
6.558941
39.35364
2020
7
11
6.017377
42.12164
2021
8

11
5.520529
44.16423
2022
9
11
5.064706
45.58235
2023
10
11
4.646519
46.46519
2024
11
11

4.262861
46.89147
2025
12
11
3.910882
46.93058
2026
13
11
3.587965
46.64355
2027
14
11
3.291711
46.08396
2028
15
11
3.019918
45.29878
2029
16
111
27.95754
447.3207
116.6251
1017.864
Duration
8.73
Years
INF Rate
Present Value
5%
165
7%
138
8%
127
9%
117
10%
108
11%
100
12%
93
13%
86


Interest rates, bond yields and inflation expectations have a correlation to each other. Movements in short-term interest rates, as dictated by a nation’s central bank, will affect different bonds with different terms to maturity differently depending on the market’s expectations of future levels of inflation.

For example, a change in short-term interest rates that does not affect long-term interest
rates will have little effect on a long-term bond’s price and yield. However, a change (or no change when the market perceives that one is needed) in short-term interest rates that affects long-term interest rates can greatly affect a long-term bond’s price and yield. Put simply, changes in short-term interest rates have more of an effect on short-term bonds than long-term bonds, and changes in long-term interest rates have an effect on long-term bonds, but not short-term bonds.

The key to understanding how a change in interest rates will affect a certain bond’s price and yield is to recognize where on the yield curve that bond lies (the short end or the long end) and to understand the dynamics between short- and long-term interest rates. With this knowledge, you can use different measures of duration and convexity to become a seasoned bond market investor. However in these segments, we have not discussed about Zero Coupon Bonds, or Sharia Bonds. Those are used for Religious beliefs and effective Tax tools for many countries across the globe, including India. In India these have to be certified by TASIS – BSE. Post which the discussion will be continued on Yield Curve (in depth), and riding of Yield Curve techniques using Convexity tools (in depth).

Key Points to remember– A Bond is a promise to pay, in the future, fixed amounts that are stated on the bond. The interest rate that a bond actually pays therefore depends on how these payments compare to the price that is paid for the bond. That price is determined in a market, so as to equate the implicit rate of interest paid on the bond to the rate of interest that buyers could get on other bonds of comparable risk and time to maturity. Figuring out what the interest rate on a bond is can be a quite tricky, since most bonds make payments for several years and of different sizes. Less tricky is to go the other direction, from the interest rate to the price of the bond.
                              

X