Bonds… Less Risky Instruments :)

bonds risk

Bonds are considered to be less risky instruments to invest in as compared to equity.

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Therefore, it is usually the risk averse investors who trade in bonds.

But, not everyone is aware of the fact that bonds too come with their own set of risks- interest rate risk being one of the most significant ones.

It is the risk associated with interest rate changing, and this causes a movement in the price of bonds.

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The following is the relationship between the two – prices of bonds are inversely related to their yield.

Yield is the implied interest offered by a security over its life, given its current market price.

Therefore, a rise in interest rates decreases the price of the bond, leaving the investor trading in bonds to incur losses.

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The rationale behind this can be understood with an example.

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Assume a bond of face value Rs.100 that offers a 7% coupon. Now, another Rs.100 bond comes out in the market, which offers a higher 8% coupon.

If the investor holding the 7% coupon tries selling it, he will not be able to sell it at its face value, since a more attractive coupon-bearing bond is available in the market at present.

Therefore, he will have to settle for a lower market price, say Rs.99. This is how prices are inversely related to yields, and this very relationship forms the basis for interest rate risk.

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To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates.

We would discuss the factors responsible for moving interest rates in our next Blog.

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This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

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Bonds are considered to be less risky instruments to invest in as compared to equity. Therefore, it is usually the riskaverse investors who trade in bonds. But, not everyone is aware of the fact that bonds too come with their own set of risks- interest rate risk being one of the most significant ones. It is the risk associated with interest rate changing, and this causes a movement in the price of bonds.

The following is the relationship between the two – prices of bonds are inversely related to their yield.

Yield is the implied interest offered by a security over its life, given its current market price. Therefore, a rise in interest rates decreases the price of the bond, leaving the investor trading in bonds to incur losses. The rationale behind this can be understood with an example. Assume a bond of face value Rs.100 that offers a 7% coupon. Now, another Rs.100 bond comes out in the market, which offers a higher 8% coupon. If the investor holding the 7% coupon tries selling it, he will not be able to sell it at its face value, since a more attractive coupon-bearing bond is available in the market at present. Therefore, he will have to settle for a lower market price, say Rs.99. This is how prices are inversely related to yields, and this very relationship forms the basis for interest rate risk.

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates. This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

1 Inflation: Interest rates are directly related to inflation i.e. if inflation rises, so do interest rates. This is because lenders demand higher interest rates to compensate for the decrease in purchasing power of the money they will be repaid in the future. This causes bond prices to fall, since bond prices are inversely related to interest rates. Inflation itself is affected by the economy’s currency and liquidity position. In India, inflation is measured by WPI (Wholesale Price Index), for which is released every week. For the week ended July 25, 2009, WPI was at (-) 1.58%. This may lead one to assume that inflation has gone down, but the reason for this low figure is a high base effect from 2008, when WPI showed doubledigit growth. Current CPI (Consumer Price Inflation) figures are in the range of 8.6-11.5% for May-June 2009.

2 Currency: A weaker rupee causes rising inflation, which in turn results in a rise in interest rates. This is because one’s purchasing power reduces – if one was paying $60 or Rs.2400 (Rs.40=$1) to buy 1 barrel of crude oil, a weaker rupee (Rs.45=$1) means the same 1 barrel will now cost Rs.2700 i.e. Rs.300 more. Similarly, a stronger rupee increases one’s purchasing power and brings down inflation, causing interest rates to fall. The latter scenario is seen as a positive for the bond market, since it leads to rising bond prices. Since 2008, the rupee has weakened significantly to Rs.47- 48 in July-August ’09.

3 Liquidity: Interest rates are directly related to liquidity. A crunch in liquidity means money is not readily available, since people are not willing to part with their cash. A lower interest rate is then offered, which increases the price of already existing bonds in the market. The vice-versa also holds true. One way of measuring the liquidity present in the system is to check the money supply measure – M3.

4 Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI. Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements. If either of these is increased, liquidity tightens and so interest rates harden (increase). Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs. A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities. When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates. When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates. MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI. This affects interest rates in the same manner as OMOs.

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in. If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future. On the contrary, an expectation of a fall in interest rates means bond prices will rise. A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above. So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

3 responses to this post.

  1. Posted by Madan on August 18, 2009 at 1:10 PM

    Thank you sir. I had the doubts of the relationship between the bonds and interest rates all the time. I believe you are the first one to post such a clear explanation. The explanation was very simple, and straight forward. But couldn’t see it anywhere else. Thanks a lot once again.

    Regards,
    Madan Kumar Rajan N

    Reply

  2. I’ve recently started a blog, and the information you provide on this site has helped me tremendously. Thank you for all of your time & work. cheers!

    Reply

  3. Posted by foods lower blood sugar on May 15, 2010 at 2:42 PM

    Great post. Hope to see much more excellent posts in the near future.

    Reply

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