Fixed Income : Playing the interest rate reduction cycle

Now that interest rates have started declining fixed deposits will no longer be the best possible options. Moreover after the recent diesel hike, inflation will spurt again making post tax real returns negative.

[ Consider this: You earn 9% on your 1 year FD while the average annual inflation is at 7%. Suppose further you pay tax at the highest bracket of 30% so you end up saving (1-Tax rate)*return = 0.7*9%= 6.3% while purchasing power of money is getting reduced at the rate of 7%. Hence post tax real returns are negative 6.3% - 7% = -0.7% ]

So where to park your cash, you don’t want the insecurities and volatility arising from equities, want something safe and secure, yet want the best returns from your bucks.

 

Enter BONDs

So you have heard about bonds and bond funds. We never bother about them while the good old bank or post office is offering fixed deposits. 

So what are these bond funds ? Where do they invest all the money ?

Let us look at the portfolio of one of the largest such funds in the Indian market

As on  30/09/12	% Net Assets
Debentures	61.4%
GOI Securities	14.0%
Commercial Paper	7.4%
Cash/Net Current Assets	6.5%
Structured Obligation	5.0%
Certificate of Deposit	2.4%
Floating Rate Debenture	2.2%
State Development Loan	1.3%

To understand in simple terms these are different form of instruments through which the Government of India (GOI) or Corporates borrow money with a fixed obligation to return. Like GOI bonds are treasury bonds raised by the Indian govt. to fund public expenditure, various corporates issue debentures which have fixed obligations and mostly unsecured (without collateral). 

In essence these are mostly fixed income instruments with an obligation to pay by the borrower. What is important to understand here is the credit worthiness of the borrower and his capacity to repay the loan. Thus any instrument from the Govt. or top corporates has very low risk of default while issuances from small companies are susceptible to a higher default risk.

That’s fine, but why all this ??? You might ask. This is because bond funds give you a very good opportunity to generate high returns during periods of anticipated fall in interest rates (and more rate cuts are expected soon from the RBI after cutting repo rate on April 2012 after the previous 13 successive hikes)

In a falling interest rate scenario, purchase of low coupon-long term bonds will provide superior returns over other fixed income instruments while in a rising interest rate scenario high coupon-short term bonds will yield superior returns. Let us see why.

Note: If you do not like the nitty gritties and technical terminologies skip the section Technicalities and jump directly to the next section Strategies

 

 The Technicalities

Bond prices vary inversely with yield. So greater the price, lower is the yield and vice versa. The convex price-yield relationship will differ among bonds or other cash flow streams depending on the coupon and maturity. The convexity of the price-yield relationship declines slower as the yield increases.

Now let us come to the change of prices of bonds. Changes in a bond’s price results from a change in yield which are due to the two aspects: Bond’s modified duration and Convexity

1) Modified Duration:
Modified duration is the percentage change in price for a nominal change in yield. Hence this will give the change in the bond price for say a 1% rise in interest rates.

MD is the slope of the curve at a given yield, mathematically is the first derivative of price with respect to yield divided by price.

2) Convexity
Convexity is a measure of how much a bond’s price-yield curve deviates from the linear approximation of that curve. It demonstrates how the duration of a bond changes as the interest rate changes.

Bond A has a higher convexity than Bond B, which means that all else being equal, Bond A will always have a higher price than Bond B as interest rates rise or fall.

The following are the three most important Bond Theorems that apply to government/corporate bonds:

          1) Bond prices will vary inversely with yields: An increase in yields leads to a     

          decrease in bond prices.
          

          2) Bond price volatility is greater for longer bonds: Bond price volatility is the 

percentage change in a bond's price for a certain change in its yield

3) Bond price volatility is much higher for bonds with lower coupon rates: Thus low coupon bonds are susceptible to much higher volatility in prices.

 
Now aided with these, we see that greater the maturity (long term) and lower the coupon the higher will be price sensitivity. So that long term and low coupon bonds will have maximum sensitivity to yield changes and in effect will show maximum price variation.

 Strategies

From our discussions we have seen bonds of higher term maturity and low coupon will show maximum sensitiveness with change in interest rates. So a 10 year bond yielding 4% returns will show much higher price volatility than a 3 year bond yielding 8% returns.

Strategy A:

So if you expect a decline in interest rates, increase the average modified duration of your bond portfolio to experience maximum price volatility.
>> Hence go for low coupon - long term bonds.

Strategy B:

If you expect an increase in interest rates, reduce the average modified duration to minimize your price decline.
>> Hence go for high coupon - short term bonds

Implementation: Indian Mutual Funds

 Now let us see how we can apply this in the context of Indian markets. With the repo  

 rate at 8% chances of finding bonds with very low coupon rates are practically nil. Thus we will focus more on long term moderate yield bonds.

Given the management integrity(!) of Indian corporates it will be very critical to invest in only quality papers. Hence we should keep very high emphasis on credit quality. (Here again we are assuming rating agencies to do a decent job on their part :) )

From the universe of long term funds we select three such funds which meets the criteria of longer-term (average maturity is high), superior credit quality (Average Credit rating of AAA) and moderate yield (slightly higher than prevailing repo rate). Also note the High Credit quality - High sensitivity to interest rates is common in all three pinning our Strategy A.

 A snapshot of these funds is as follows: 

SBI Dynamic Bond Fund

 Kotak Bond Deposit

IDFC Dynamic Bond Plan

These are at this point of time very good candidates for someone wanting the safety of fixed deposits coupled with a chance to get very good returns from the investment as well. Moreover the tax efficiency of debt funds as explained here makes it an even more compelling investment decision.

  

In the long term, debt funds are far more tax efficient than fixed deposits. After one year of investment, the income from a debt fund is treated as a long-term capital gain and is taxed at either 10% or at 20% after indexation. In indexation, the cost of investment is raised to account for inflation for the period the investment is held. The longer you hold a debt fund, the bigger is the indexation benefit. There is also no TDS in debt funds. In fixed deposits, if your interest income exceeds Rs 10,000 a year, the bank will deduct 10.3% from this income.

If you are not liable to pay tax, you will have to submit either Form 15H or 15G to escape TDS. The other problem is that the income from fixed deposits is taxed on an annual basis. You may get the money after the deposit matures 5-6 years later but the income is taxed every year. In debt funds, the tax is deferred indefinitely till the investor redeems his units. What's more, the gains from a debt fund can be set off against short-term and long-term capital losses you may have made in other investments.

References:

Modified Duration
http://www.investopedia.com/terms/m/modifiedduration.asp#axzz290HlYZZ5

Convexity
http://www.investopedia.com/terms/c/convexity.asp#axzz290HlYZZ5

Bond Price Theorems
http://www.drtaccounting.com/2008/04/corporate-bond-pricing-theorems.html

Fund Details
Kotak http://www.valueresearchonline.com/funds/newsnapshot.asp?schemecode=709
IDFC  http://www.valueresearchonline.com/funds/portfoliovr.asp?schemecode=1347
SBI     http://www.valueresearchonline.com/funds/newsnapshot.asp?schemecode=2025

Tax Efficiency
http://articles.economictimes.indiatimes.com/2012-06-25/news/32409087_1_debt-fund-fund-house-maturity-plan