Direct & Indirect Taxes, Tax Ready Reckoner, Tax Management, Tax Act. & Rules, Tax Planning & Tax Savings.

Direct & Indirect Taxes, Tax Ready Reckoner, Tax Management, Tax Act. & Rules, Tax Planning & Tax Savings.

Bond (Fixed Income) Concepts under Mutual Fund Investment

Fixed Income Bond Mutual Fund
Fixed Income Bond Mutual Fund

1. What is a Bond (Fixed Income)?

When you purchase a bond, you effectively are lending a company or the government your money. The bond issuer is the borrower. It agrees to pay whoever holds the bond interest on a regular basis, and then to return the principal on the loan when the bond matures. This can make bonds attractive for people looking for a stable investment.

Unlike a stock where you’re not sure of future cash flows of the company, with bonds you know exactly what they’re going to be.  The only risk is that the issuer ends up defaulting and doesn’t pay the debt. The flip side of bonds’ low risk is that they have less potential than stocks for high returns.

The rate of interest a bond must pay depends in part on interest rates prevalent on the date of issue. So in 2011, when interest rates fixed by RBI were high, new bonds issued at that time gave high rate of return whereas in 2017 when interest rates are relatively lower, new bonds getting issued are offering very low rate of return. Rate of interest is also in part dependent on the creditworthiness of the buyer. That’s why Central Govt securities typically carry the lowest yields in the bond market. Large, stable corporations pay a slightly higher rate. Bonds from companies with poor credit ratings are known as junk or high-yield bonds. Junk bonds pay high rates to compensate for the risk that they will default.

Another variable key is a bond’s maturity date. That’s when the bond pays back its principal. Generally, the farther away the maturity date, the higher the interest a bond must pay.

Except in cases of default, investors know exactly what they can expect to make on a bond so long as they hold it to maturity. But bonds can also be bought or sold on the bond market, which means a bond’s current value if you decided to sell it can fluctuate. For example, when interest rates rise, the value of existing bonds on the market will fall. To understand why this is, imagine you hold a 2% bond and rates rise to 2.5%. With a 2.5% yield now available on the market, no one will want to buy your paltry 2% bond, unless you cut the price. Likewise, bond prices rise when interest rates fall.

If you own bonds through a mutual fund, you don’t have the option of waiting until the bonds in the portfolio mature. You own a constantly changing mix of bonds, so the total return of the fund is determined partly by the daily value of those bonds on the market.

Since bonds are intended to be bought and sold, all the certificates of a bond issue contain a master loan agreement. This agreement between issuer and investor (or creditor and lender), called the “bond indenture” or “deed of trust,” contains all the information you did normally expect to see in any loan agreement, such as :

1)  Amount of the loan : –

The “face amount” “par value” or “principal amount” is the amount of the loan issuer has agreed to repay at the bond’s maturity/

2)  Rate of Interest :-

Bonds are issued with a specified “Coupon” or “Nominal” rate which is the rate of interest.

3)  Schedule or Form of Interest Payments :-

Interest is paid on most bonds at six-monthly or annually intervals, usually on either the fifteenth or thirty of the month.

4)  Term :-

A bond’s “Maturity” or the length of time until the principal is repaid, varies greatly and is mostly more than 5 years. Debt that matures in less than a year is a “money market instrument” – such as commercial paper.

5)  Call features (if any) :-

A “call feature”, if specified, allows the bond issuer to “call in” the bonds and repay them at a predetermined price before maturity.

6)  Refunding :-

If, when bonds mature, the issuer doesn’t have the cash on hand to repay bondholders, it can issue new bonds. This process is called “refunding”.

Let’s see few examples of Bonds issued by different companies recently –

[Bond (Fixed Income) Mutual Fund-1]

There are two dominant issuers of Bonds: Corporates and the government. Both Private and Public Corporations issue bonds as a way to borrow large sums of money for expansion, acquisition or other use. The central government of our country raises funds through the issue of dated securities, which are long term bonds with maturity ranging from 2 years to 30 years and treasury bills, which are short term bonds with the maturity ranging from 91 days to 364 days. These treasury bills are issued through auction carried out by the reserve bank of India. State government raise money through state development loans generally. Local bodies of various states like municipalities also tap the bond market from time to time.

2.  Bonds vs Debentures?

Generally, in the Indian context, you find the word debenture and bonds being used interchangeably. A debenture is a debt instrument which is not backed by any specific security; instead the credit of the company issuing the same is the underlying security.

A debenture is a debt instrument which is not backed by any specific security; instead the credit of the company issuing the same is the underlying security. However, Bond is issued by large companies, government & PSUs and are mostly backed by some assets.

Major Difference Between Debentures and Bonds

  • Bonds are secured in comparison to debentures
  • Bonds are usually issued by the government bodies while debentures are issued by private companies.
  • Bond offers lower interest rate in comparison to debentures
  • Bondholders do not receive periodic payments and receive the principal plus interest at the end of the term whereas debenture holders receive periodic interest payments.
  • Bond is a long term debt instrument that promises to pay a fixed annual interest over a specific period whereas debenture is a medium term debt instrument.

3.  How Bond Market works?

Bonds are simply a way for governments and companies to borrow money. Instead of borrowing money from a bank, a company or government can sell bonds to a large group of investors to raise the funds it needs to operate or grow. Bonds are a simple instrument, which have a fixed coupon rate or interest rate, fixed Maturity Period and Fixed Principal.

Example, if ABC company has issued a bond, then they will mention the Principal Rs 1000, Maturity Period – 7 Years and Interest Rate – 8%/annum. So, you will pay them Rs 1000 for 1 bond and you will get 8% per annum every year for next 7 years and then after 7 years, you will get your Rs 1000 back. Simple!

But what if you don’t want to keep it for 7 years? And want to sell it earlier and here all the complications start. So, Bond Market is like a Stock market where Bonds are bought and sold before expiry and their prices changes frequently. Why?

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With bond investing, prices go up and down in response to two factors: changes in interest rates and changes in credit quality. Managing interest rate risk has become the most critical variable in the management of bond portfolios.

Interest Rate Risk

“Interest rate risk,” also known as “market risk,” refers to the propensity bonds have of fluctuating in price as a result of changes in interest rates.

All bonds are subject to interest rate risk.

Let us suppose you bought a 10-year bond of Face Value Rs 1000, with interest rate 8%. now, after 2 years you now wish to sell your bond but interest rates which other bonds are offering for the same maturity are currently at 10%. How can you convince someone to purchase your bond, with an interest of 8%, when he can buy new bonds with a 10% interest?

Well, there is only one thing you can do: You sell the bond at discount. In fact, the price at which a buyer would buy your bond as readily as a new issue is that price at which your bond would now yield 10%. The price at which you can sell a 1000 Rs bond in such a scenario will be Rs 885. But you will object, if I sell my Rs 1000 bond for approx. Rs 885, I have lost Rs 115 per bond!

That is precisely the point. This is exactly opposite if suppose interest rates would have decreased to 6%, then you could have sold your investment at premium of approx. Rs 1130, a gain of Rs 130 on each bond. Therefore, bond prices have inverse relationship with interest rates. If interest rate increases, bond prices decreases and vice versa.

In the bond investing area, significant changes in the interest rate environment are not hypothetical. During the past decade, swings of 2% have occurred on several occasions over periods of a few weeks or a few months. Here are examples from chart of Indian 10 Year Bond monthly yield –

[Bond (Fixed Income) Mutual Fund-2]

With bond investing, the basic principle is that interest rates and prices move in an inverse relationship. When interest rates went from 7.08% to 5.26%, that represented a decrease in yield of over 25%. The price of the bond increased by a corresponding amount. On the other hand, when interest rates increases, then the price of the bond goes down.

Now important thing to note here is that price doesn’t change only when RBI changes interest rates but it changes on a daily basis? Why? Because of the expectation of change based on number of internal & external factors – Inflation figures, Economic Growth figures, Global Liquidity etc.

Inflation:

When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation.

As a result, with rising inflation, interest rates tend to rise. The opposite happens when inflation declines.

Economic Growth:

If the economic growth of an economy picks up momentum, then the demand for money tends to go up, putting upward pressure on interest rates. Whereas, when Economy slows down, RBI has pressure to decrease interest rate so that loans become cheaper which could increase economic activity.

Global liquidity:

If global liquidity is high, then there is a strong chance that liquidity will chase higher interest rates in the country and more money flows in, which would put a downward pressure on interest rates.

So, with all these factors and even the different expectations on these factors leads to dynamic bond market which changes every day very similar to how expectation of a good/bad performance of a company changes its stock price daily.

Other way which impacts Bond price is credit quality of the Bond. So, taking the same example, if interest rate has decreased to 6% after 2 years when we want to sell the bond, but the company whose bond we are holding is not performing well and its credit quality is becoming questionable, then in that case we may not be able to demand the premium on our bond and may actually have to sell at discount. So, all these factors keeps the bond market dynamic. Due to these factors, our Debt investments can give us negative returns too.

4.  What is Money Market and what are major Money Market instruments in India?

There are two kinds of markets where borrowing and lending of money takes place between fund scarce and fund surplus individuals and groups. The markets catering the need of short term funds are called Money Markets while the markets that cater to the need of long term funds are called Debt Markets.

The term ‘Money Market’, according to the Reserve Bank of India, is used to define a market where short-term financial assets are traded. These assets are a near substitute for money. So, essentially, the money market is an apparatus which facilitates the lending and borrowing of short-term funds, which are for a duration of under a year. Short maturity period and high liquidity are two characteristic features of the instruments which are traded in the money market. The nature of the money market transactions is such that they are large in amount and high in volume. Thus, the entire market is dominated by few of large players. The key players in the organized money market include Governments (Central and State), Mutual Funds, Corporates, Commercial / Cooperative Banks, Public Sector Undertakings (PSUs), Insurance Companies, Non-Banking Financial Companies (NBFCs) & Discount and Finance House of India (DFHI).

Here are the major Money Market Instruments issued in India –

Treasury Bills (T-Bills)

Issued by the Central Government, Treasury Bills are known to be one of the safest money market instruments available. However, since treasury bills carry zero risk and therefore, the returns one gets on them are not attractive. Treasury bills come with different maturity periods like 3-month, 6-month and 1 year and are circulated by primary and secondary markets.

Certificate of Deposits (CDs)

A Certificate of Deposit (CD) is a money market instrument which is issued in a dematerialised form against funds deposited in a bank for a specific period. Certificates of Deposit are issued by scheduled commercial banks and select financial institutions in India as allowed by RBI within a limit.

Commercial Papers (CPs)

Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities.

Repurchase Agreements (Repo)

Repurchase Agreements: Repurchase transactions, called Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities viz. GOI and State Govt Securities, T-Bills, PSU Bonds, Corporate Bonds etc. Under repurchase agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities.

Banker’s Acceptance (BA)

Banker’s Acceptance or BA is basically a document promising future payment which is guaranteed by a commercial bank. The bill may be drawn, for example, by an exporter on the importer who in turn gets guarantee by their country’s commercial bank and sold by exporter on the open market at a discount to cash in the money immediately.

Similar to a treasury bill, Banker’s Acceptance is often used in money market funds and specifies the details of the repayment like the amount to be repaid, date of repayment and the details of the individual to which the repayment is due. Banker’s Acceptance features maturity periods ranging between 30 days up to 180 days. Bankers acceptances have low credit risk because they are backed by the importer, the importer’s bank, and the imported goods

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Call/Notice Money

It means a loan for very short period i.e., one to fourteen days. The loans are repayable on demand at the option of either the lender or the borrower. Call money is money at call. Call money market is a market where short-term surplus funds of commercial banks, and other financial institutions, are traded. The participants, usually, borrow and lend call/ notice money for one day/ for a period up to 14 days. The call money market is the highly liquid market and there is no collateral involved, and accounts for a large share of the total turnover of the money market. Overnight Debt Funds invest their large portfolio in this instrument.

Commercial Bills

Commercial bills arise out of trade transactions. When goods are sold on credit the seller draws a bill on the buyer for the due amount. The buyer accepts it agreeing to pay the amount after specific period to the person mentioned in the bill or to the bearer of the bill. It is drawn for a short period ranging from three to six months. These bills are transferable by endorsement and delivery and can be discounted or rediscounted. In a bill market the bill of exchanges are bought and sold.

Commercial banks, co-operative banks, financial institutions, mutual funds etc. can participate in the bill market. Thus, the seller can get payment immediately by discounting the bills with commercial banks or other financial intermediaries. At maturity date the intermediary claims the amount of money from the person who has accepted the Bill.

Very similar concept as Banker’s acceptance. Banker’s acceptance is majorly used for export import transactions whereas commercial bills is used for other local transactions.

5. Type of Bonds issued by Government?

Treasury Bills:

Treasury bills (T-bills) are money market instruments, i.e., short-term debt instruments issued by the Government of India, and are issued in three tenors—91 days, 182 days, and 364 days. The T-bills are zero coupon securities and pay no interest. They are issued at a discount and are redeemed at face value on maturity.

Cash Management Bills:

Cash management bills (CMBs)3 have the generic characteristics of T-bills but are issued for a maturity period less than 91 days. Like the T-bills, they are also issued at a discount, and are redeemed at face value on maturity.

Dated Government Securities:

Dated government securities are long-term securities that carry a fixed or floating coupon (interest rate), which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. S

State Development Loans:

State governments also raise loans from the market. State Development Loans (SDLs) are dated securities issued through an auction similar to the auctions conducted for the dated securities issued by the central government. Interest is serviced at half-yearly intervals, and the principal is repaid on the maturity date. Like the dated securities issued by the central government, the SDLs issued by the state governments qualify for SLR.

Types of Dated Government Securities –

Fixed Rate Bonds: These are bonds on which the coupon rate is fixed for the entire life of the bond. Most government bonds are issued as fixed rate bonds. Floating Rate Bonds:

Floating rate bonds are securities that do not have a fixed coupon rate. The coupon is re-set at pre-announced intervals (say, every 6 months, or 1 year) by adding a spread over a base rate.

Zero Coupon Bonds:

Zero coupon bonds are bonds with no coupon payments. Like T-Bills, they are issued at a discount to the face value. The Government of India issued such securities in the 90s; it has not issued zero coupon bonds after that.

Capital Indexed Bonds:

These are bonds, the principal of which is linked to an accepted index of inflation with a view to protecting the holder from inflation. Capital indexed bonds, with the principal hedged against inflation, were first issued in December 1997. These bonds matured in 2002. RBI didn’t issue new bonds as they were not accepted well by market participants. The government then worked on Inflation Indexed Bonds wherein the payment of both the coupon as well as the principal on the bonds would be linked to an Inflation Index (Wholesale Price Index). In this, the principal will be indexed and the coupon will be calculated on the indexed principal. In order to provide the holders protection against actual inflation, the final WPI was used for indexation.

Bonds with Call/Put Options:

Bonds can also be issued with features of optionality, wherein the issuer can have the option to buy back (call option) or the investor can have the option to sell the bond (put option) to the issuer during the currency of the bond. The optionality on the bond could be exercised after the completion of five years from the date of issue on any coupon date falling thereafter. The government has the right to buy-back the bond (call option) at par value (equal to the face value), while the investor has the right to sell the bond (put option) to the government at par value at the time of any of the half-yearly coupon dates.

Special Securities:

In addition to T-Bills and dated securities issued by the Government of India under the market borrowing program, the government also issues special securities, from time to time, to entities such as oil marketing companies, fertilizer companies, the Food Corporation of India, and so on as compensation to these companies in lieu of cash subsidies. These securities are usually long-dated securities carrying a coupon with a spread of about 20–25 basis points over the yield of the dated securities of comparable maturity. These securities are, however, not eligible SLR securities, but are eligible as collateral for market repo transactions. The beneficiary oil marketing companies may divest these securities in the secondary market to banks, insurance companies, primary dealers, etc., for raising cash.

6. What is Corporate Debt & Type of Corporate Debt?

Corporate debt is the money borrowed by the companies to serve their financial needs, that they are unable to meet otherwise. Companies wanting to borrow money can resort to loans and other functional options. They can explore other debt types such as commercial paper and bonds. Short-term corporate debt is issued as commercial paper whereas, long-term debt is issued as bonds. Bonds allow companies to raise funds by selling a repayment promise to interested investors. Institutions and individual investment organizations can procure bonds that typically come with a predefined interest rate, or coupon. If an entity wants to raise 10 lacs to purchase new machinery, for instance, it can provide the public with 1,000 bonds each worth rupees 1,000. Once individuals or other companies purchase the bonds, the holders are guaranteed a face value on a given date, commonly known as the maturation date. This amount is in addition to regular interest on the bond throughout the period the bond is active.

Bonds work on a similar principle to that of conventional loans. However, a company is the one borrowing while investors are either creditors or lenders.

Type of Corporate Bonds

Based on Issuer

Issuers of Corporate Bonds can be broadly classified in following classes:

  • Bonds issued by Local Bodies
  • Bonds issued by Public Sector Units
  • Bonds issued by Financial Institutions
  • Bonds issued by Banks
  • Bonds issued by Corporates

Based on Maturity Period

Short Term Maturity:

Security with maturity period less than one year. Medium Term: Security with maturity period between 1year and 5 year. Long Term Maturity: Such securities have maturity period more than 5 years

Perpetual:

Security with no maturity. Currently, in India Banks issue perpetual bond.

Based on Coupon

Fixed Rate Bonds:

Have a coupon that remains constant throughout the life of the bond.

Floating Rate Bonds:

Coupon rates are reset periodically based on benchmark rate.

Zero-coupon Bonds:

No coupons are paid. The bond is issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest

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Based on Option

Bond with call option:

This feature gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the bond’s maturity at predetermined price and date.

Bond with put option:

This feature gives bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk.

Based on redemption

Bonds with single redemption:

In this case principal amount of bond is paid at the time of maturity only.

Amortising Bonds:

A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal, is called an amortizing bond.

7. What is Commercial Paper (CP)?

Commercial Paper (CP) is an unsecured and negotiable money market instrument issued in the form of a promissory note issued by companies to raise funds generally for a time period up to one year.

CPs are issued by highly rated corporate entities to raise short-term funds for meeting working capital requirements directly from the market instead of borrowing from banks. CPs are not usually backed by any form of collaterals and are allowed to be issued only by corporate with high quality debt ratings. The issue of CP seeks to by-pass the intermediary role of the banking system. CPs have been introduced in the Indian market so as to provide a diversified source of funding to the borrowers as well as an additional investment option to the investors.

CPs usually feature a fixed maturity period which can range anywhere from 1 day up to 270 days. Highly popular in countries like Japan, UK, USA, Australia and many others, Commercial Papers promise higher returns as compared to treasury bills and are automatically not as secure in comparison. Commercial papers are actively traded in secondary market.

All CP issuers have to get credit rating from leading organizations. Here are few recent examples of CP issued –

[Bond (Fixed Income) Mutual Fund-3]

8. What is Certificate of Deposits (CDs)?

CDs are a form of fixed term-deposit which have a fixed interest rate and are accepted by commercial banks. CDs are usually issued in Demat form or as a Promissory Note.

All scheduled banks except Regional Rural Banks (RRBs) and Co-operative banks are eligible to issue CDs. They can be issued to individuals, corporates, trusts, funds and associations.

The Certificates of deposits (CDs) were introduced in June, 1989 with the primary objective of providing a wholesale resource base to banks at market related interest rates. The instrument was effectively used to cover certain asset sources and has since emerged as instrument for effective asset-liability management. First announced in 1989 by RBI, Certificate of Deposits have become a preferred investment choice for organizations in terms of short-term surplus investment as they carry low risk while providing interest rates which are higher than those provided by Treasury bills. Certificate of Deposits are also relatively liquid, which is an added advantage, especially for issuing banks. Like treasury bills, CDs are also issued at a discounted price and their tenor ranges between a span of 7 days up to 1 year. However, banks issue Certificates of Deposits for durations ranging from 3 months, 6 months and 12 months. They can be issued to individuals (except minors), trusts, companies, corporations, associations, funds, non-resident Indians, etc.

[Bond (Fixed Income) Mutual Fund-4]

9.  What is Treasury Bill (T-bills)?

Treasury Bills are basically instruments for short term borrowing issued by the Central Government. They have maturities of less than 1 year and are part of money market in India.

Features of T-bills:

  • T-bills are issued only by Central Government.
  • They are used by Government to manage their short term liquidity.
  • They have assured yield and negligible risk of default.
  • They are issued in primary auction conducted by RBI on behalf on Government of India.
  • T-bills are issued at a discount and redeemed at par.

Suppose a Rs.100 91 day T-bill is issued at Rs.98.2 i.e., at discount. After maturity, investor will get Rs.100 as maturity of each bill. So, Rs.1.8 will be the interest rate. This interest rate or discount rate is market driven and is decided in the scheduled auction.

At present, the Government of India issues three types of treasury bills through auctions, namely,

  • 91-day,
  • 182-day and
  • 364-day.

Here are examples of recently issued Bills –

[Bond (Fixed Income) Mutual Fund-5]

10. What are NCDs (Non-Convertible Debentures)?

Non-convertible debentures (NCDs) are fixed income instruments where you are promised a certain interest for a fixed tenure. It is a type of Corporate debt where companies issue NCDs when they want to raise money for various needs such as expansion. The NCD is a promise that the company will pay back the money at a promised interest rate. It is closed-ended debt instrument, which means it is available for subscription only for a particular period. The main attraction of NCDs was high return to investors in comparison to other fixed income instruments like bank deposits.

Why it is call Non-convertible? –

There are Convertible debentures too which mean after the specified time, these debentures are converted into shares (stocks) of the company. Up to that conversation, you will enjoy the fixed specified coupon (interest rate) on such debentures. After that, your earnings depends on price appreciation of the stock or the dividend income you receive (if the company declares it). Non-Convertible Debentures, which we are discussing here, on the other hands, will never be converted into shares (stocks) of the company. Investors who invest in such non-convertible debentures will enjoy fixed interest rate up to maturity and after that return of principal (exactly like Bank FDs).

An NCD can either be secured or unsecured. A secured NCD is backed by the issuing company’s assets. This means that the company has to fulfil its debt obligation whatsoever. However, that’s not the case for unsecured NCDs. This makes secured NCDs safer since they have a lower default risk.

Every company that seeks to raise money through an NCD is rated by agencies such as Fitch Ratings, CRISIL, ICRA and CARE. These rating agencies rate the company based on its ability to service its debt on time. So, a lower rating means a higher credit risk. Few recently launched NCDs –

[Bond (Fixed Income) Mutual Fund-6]

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