by Anand Saxena
There are other schemes like Post Office Monthly Income Scheme, National Savings Certificates (NSC) and Public Provident Fund (PPF) but I will avoid discussing these schemes as they are not the optimal investment vehicles for fixed income.
MUSING 33: MY NAME IS BOND
“Everyone should keep a minimum of 25 percent of investments in bonds. This cushion will give you the courage to keep the rest of your money in stocks even when stocks stink”
–Benjamin Graham, ‘The Intelligent Investor’
With a legend like Benjamin Graham, the father of value investing and the mentor of Warren Buffet, making this statement, bonds deserve a deeper look and understanding. Incidentally, Graham suggested a maximum of 75 percent holding in bonds meaning a minimum of 25 percent in equity instruments.
Similar to equity investments where mutual funds remain the mainstay, in debt investing too, a similar path could be followed to achieve long or short-term objectives. Debt mutual funds come with an amazing array of eclectic options and mainly invest in bonds. It is hence important to understand how the bond market functions before I take you through the path of debt mutual funds.
Bonds are issued by the governments, corporations, financial institutions and banks to raise money. Governments may do it to fund massive social and infrastructure projects; corporations may do it to raise capital for expansion of their business and banks may do it to raise money on behalf of the government or corporations. Be that as it may, a bond is simply an IOU or a promissory note from the borrower to return the money of the lender (principal amount) along with a pre-decided interest.
To take an example, let’s assume that Anshreya buys a bond worth ₹10,000 issued by a corporation called ‘I Build India.’ The bond maturity is after 10 years with a ‘coupon rate’ of 5 percent. Let’s demystify this jargon. The coupon rate is simply the rate of interest that Anshreya will be paid by ‘I Build India’ for the entire period of investment i.e. 10 years in this example. This is normally paid half-yearly (in this example 5 percent coupon rate will be paid as 2.5 percent half-yearly,) so Anshreya will receive ₹250 (2.5 percent of ₹10,000) every six months. At the end of 10 years, they get their principal amount (also called ‘face’ or ‘par’ value) back in full. If this bond was a ‘zero coupon bond’ then there would have been no interest payment in the interim period but at the end of 10 years, the par value and the interest accrued at 5 percent would have been paid together.
Like all investments bonds too must suffer from some risks, and they do. These are called interest rate risk, credit risk and inflation risk.
Interest Rate Risk
The benchmark interest rates are decided by the central bank (for India it is the Reserve Bank of India or RBI.) These rates are called the ‘Repo or repurchase rates’ meaning the rates at which the RBI will lend money to other commercial banks (like SBI or HDFC.) If these rates are reduced by RBI, obviously, the commercial banks can then lend money to their borrowers (common persons like you and me who take loans from banks for various purposes like buying a house or businesses who take loans to expand or start-up) at lesser rates of interest.
Interest rate risk arises because, with the change in the interest rates in the country, the value of bonds goes up and down. To take our example further, when Anshreya bought the bond, the prevailing interest rates were 5 percent and one year later they were reduced to say, 4 percent. Obviously, any investor who buys the same bond now will only get 4 percent interest and hence the bond held with Anshreya becomes a lucrative investment because it will fetch 1 percent higher return. So, Anshreya can, if they wish, sell their bond at a premium. The reverse will happen if the interest rates were increased by 1 percent. The bonds held with Anshreya will become less attractive because newer bonds are fetching higher returns. To sum up, bonds go down in value as interest rates rise and vice versa.
Credit Risk
Ok, so Anshreya bought this bond on the promise by ‘I Build India’ that it will pay back not only the principal amount but also coupon rate of 5 percent. But what happens if ‘I Build India’ corporation defaults on its promise? It can happen for variety of reasons like the business model being faulty and so on. Anshreya thus faces the prospect of not even getting her principal back leave aside the interest. This is termed as the credit risk. Obviously, bonds issued by the government will have almost 100 percent chance of not defaulting and are accordingly rated higher than corporate bonds. Yes, there are credit ratings for bonds based on their probability of default. These range from AAA to BBB– (bonds with these ratings are called investment grade bonds) and BB+ to D (bonds with these ratings are called non-investment grade or Junk bonds.)
One obvious question is why anyone would invest in a non-investment grade bond at all? It is because these bonds will always have a higher coupon rate and are thus enticing to the investors. Risk and rewards are thus linked in debt investment too, similar to what we saw in equity investments. There are categories of debt mutual funds which specifically invest in this segment of bonds as we shall see in a later musing.
One more small but important issue. If ‘I build India’ declares bankruptcy and its assets are to be sold to pay off its investors (persons holding equity in form of shares of the corporation) and creditors (like Anshreya who had loaned money by buying bonds) the first lien on this money will be of bondholders and not equity holders. Thus, despite credit risk looming, a bond investor will be better off vis-a-vis an equity investor. Inherently bonds are less risky over a shorter period of time.
Inflation Risk This risk is easy to understand if we remember the musing on inflation. If Anshreya bought her bond when the inflation rate was 4 percent, she was to get a real rate of return of 1 percent (coupon rate 5 percent minus inflation rate 4 percent.) If inflation rose to 6 percent after a year, the real rate of return from bond becomes minus 1 percent. Obviously, at this stage, her bond is not lucrative to the market. Reverse happens when inflation rates drop. To sum up, Bond prices go down when inflation goes up and vice versa; so the correlation between bond prices and inflation and interest rates is same.
Inflation-Indexed Bonds These bonds, called Treasury inflation protection securities (TIPS – we read about them in the musing on model portfolios) are quite popular in Western economies. Essentially, these bonds offer a fixed interest rate which is higher than the inflation rate. In India too, RBI had launched inflation-indexed bonds in 2013, whose yield was CPI+1.5 percent, meaning that the investor will, on maturity, get an interest of prevailing inflation rate plus 1.5 percent. With falling inflation rates these bonds have lost their sheen but nevertheless are a good bet in high inflation scenario.
Bonds are generally a good bet to have in falling markets due to two reasons. Firstly, as markets crash, there is a tendency in general investors to panic and sell their stocks and this money, to a great extent gets deployed in bonds. Secondly, in falling markets, governments want to stimulate the market and one of the ways is by reducing the interest rates for easy availability of credit. As we have learnt before, this fall in interest rates make the existing bonds lucrative. The reverse is generally true in rising markets. Ironically, the investors usually react opposite to what they should. In falling markets, the stocks are available on discount and hence an intelligent investor should buy as much of stocks as possible. Remember the iconic quote by Warren Buffet, “Be greedy when others are fearful.” Normally, bonds tend to do well when stock market goes in a tailspin, but not always. In 2008 crash, both stocks and bonds fell together. Anyway, holding an optimum percentage of bonds in the portfolio remains a sine qua non for the reasons discussed above.
There is one more issue to be tackled in this musing before we move to the nuts and bolts of bond investing—bond yields. Since bonds are fixed income instruments, they promise a half-yearly, yearly or on maturity cash flow to the investor. Therefore, to assess true value of a bond is a tricky affair. Normally, if one uses the formula of simple interest, one calculates either the ‘cou
pon yield’ or ‘current yield.’
Coupon Yield is the simplest to understand. It is the coupon rate that has been promised right in the beginning when the bond was purchased. It is nothing but one-year coupon payment divided by par value of the bond. So, in our example coupon yield will be 5 percent (500(annual coupon payment)/10,000 (par value of bond.))
Current Yield will be different to the coupon yield in different time periods as the price of bond will move up or down due to reasons we have discussed. So, if the same bond (par value ₹10,000) is selling at ₹12,000, the current yield will be 4.2 percent (500(annual coupon)/12,000 (current price of bond.)) If the same bond was selling at a discount at ₹8,000, the current yield will be 6.3 percent.
Yield to Maturity (YTM) is the best yardstick to assess the true value of a bond and this is the yield an investor should look at. It is simple to understand and assumes that if all the coupon payments during the maturity lifetime of bonds were invested and gave the same rate of return as the original coupon rate (5 percent in our example,) the amount at maturity will be even larger. Like the current yield, YTM will be less if the bond is bought at a premium and vice versa.
To sum up this musing, “The stock portion of your portfolio is the place to take risk, not the bond portion, where the purpose is to shelter you from market downturns and provide ready liquidity. For the most part, then, you should keep the maturity of your bond portfolio between one and five years107.”
MUSING 34: DEBT MUTUAL FUNDS
Having understood the necessity of having a part of our portfolio in fixed income or bonds, the next issue to tackle is how does one go about selecting the correct kind of bond? There is a bewildering array of bonds out there—government bonds, capital gains bonds, tax-free bonds, non-convertible debentures and so on. How does one compare various types of bonds and be reasonably sure that the choice will not turn out to be a fiasco later?
I would like to compare individual bond picking to individual stock picking—a loser’s game. It would be better to have a diversified basket of bonds which invest in multitude of companies thus automatically reducing the chances of a bad investment choice (remember credit risk from previous musing?) This is possible by picking a debt mutual fund which is tailored to your requirements as an investor. Yes, today there are debt mutual funds which can take care of all your investing needs and broadly function on two principles: duration and accrual strategy.
Duration Strategy: We have seen the interest rate risk wherein the bonds become pricier as the interest rates fall and vice versa. Duration strategy targets this risk wherein the fund manager, anticipating the direction of interest rates, decides the duration of maturity of the bonds held in the portfolio. So, if the fund manager anticipates interest rates to fall, he buys longer duration bonds. If his call goes correct, investors end up making gains as the bonds held can be sold at a premium.
Accrual Strategy: Funds in this category target the ‘credit risk’ of bonds. So, the fund manager looks for companies which currently have a lower credit rating but strong fundamentals. The fund manager bets on this fact and anticipates the credit rating to improve over time which will increase the price of the bond. Very loosely, this strategy can be compared to the value investment strategy of equity mutual funds.
Overall, accrual strategy is riskier as a company whose rating drops further or in the worst case scenario, it defaults on its payments, the results for the investors could be devastating. For a beginner debt investor, duration strategy debt funds are better choice108. Remember though, that your principal amount invested in debt mutual funds is not assured and to that extent, both strategies can result in loss of money. This risk however, is eliminated to a great extent by diversification (mutual funds holding bonds of 40-50 companies) and thus avoiding ‘concentration risk’ in any one company.
Securities and Exchange Board of India (SEBI) has further simplified the process of investing in mutual funds, including debt funds, by creating clear-cut categories, for both duration and accrual funds. Let’s go over these before progressing further109.
Duration Funds
Serial Category of Scheme Scheme Characteristics
1 Overnight fund Investment in overnight securities having maturity of 1 day
2 Liquid fund Investment in debt and money market securities with maturity of up to 91 days only
3 Ultra-short duration fund Investment in debt and money market instruments. Duration of the portfolio between 3 and 6 months
4 Low duration fund Duration of the portfolio is between 6 and 12 months
5 Money market fund Investment in money market instruments having maturity up to 1 year
6 Short duration fund Investment in debt and money market instruments. Duration of the portfolio is between 1 and 3 years
7 Medium duration fund Investment in debt and money market instruments.
Duration of the portfolio is between 3 and 4 years
8 Medium to long duration fund Investment in debt and money market instruments. Duration of the portfolio is between four and seven years
9 Long duration fund Investment in debt and money market instruments. Duration of the portfolio is greater than 7 years
10 Dynamic bond Investment across durations
See how easy it becomes for an investor who wishes to take a call on duration based debt investing. A wonderful array of options, ranging from overnight parking of money to a longer duration of more than 7 years become available on the click of a mouse or finger. One can even invest across duration categories through dynamic bond funds.
Few guidelines for duration funds that I wish to put across— firstly, all the funds that invest in bonds with maturity up to 3 years are likely to give more stable returns as anticipating interest rate movements beyond this time period may be more difficult. Secondly, dynamic bond funds are ideal for mitigating risk as they invest in instruments across time horizons. And thirdly, duration funds can also show volatility (though not as frequently) akin to equity funds—returns from dynamic bond funds have dropped to only 3.35 percent in 2017 as compared to 13.4 percent in 2016110.
Accrual/Miscellaneous Funds
Serial Number Category of Scheme Scheme Characteristics
1 Corporate bond fund Minimum investment in corporate bonds—80 percent of total assets (only in highest rated instruments) AAA rated
2 Credit risk funds Minimum investment in corporate bonds—65 percent of total assets (investment in below highest rated instruments-AA rating or below)
3 Banking and PSU fund Minimum investment in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions—80 percent of total assets
4 Gilt Funds Minimum investment in government securities (G-secs)—80 percent of total assets (across maturity)
5 Gilt Funds with ten year constant duration Minimum investment in G-secs—80 percent of total assets such that the Macaulay duration (weighted average time till receipt of cash flows) of the portfolio is equal to 10 years
6 Floater Fund Minimum investment in floating rate instruments—65 percent of total assets
Remember we discussed the credit risk in bonds? Here SEBI has more or less laid out the funds category depending on your risk appetite. So, if you want to take a call on below highest rated bonds, go for credit risk funds. You want safer investment; go for corporate bond or banking and PSU fund and so on.
A 10-year G-sec (government securities) bond is considered bond market benchmark akin to Sensex for equity investments. Like we saw for duration funds, even long duration Gilt Funds, which invest in G-secs, have been volatile of late, with returns dropping to mere 2.3 percent in 2017 against 15.6 percent in 2016111.
A New Paradigm of Investing
Having traversed the journey of understanding the debt and fixed income instruments, I would like to outline a different paradigm for investing in these instruments. The instinctive reflex of investing in FD and RD needs to be replaced with a more investment-friendly and higher return
methodology.
So, we start with the FD, the most favoured instrument for us Indians and see how we can replace it with something better.
Duration: FD can clearly not beat debt mutual funds on this count. The flexibility of investing even in an overnight fund to longer than 7 years duration and ability to invest across duration categories is precious.
Returns: FD returns have been going down over last few years and currently, after adjusting for inflation, barely give any worthwhile returns. Debt funds, on the other hand, have given very handsome returns (double digits in 2016.)
Liquidity: FD, if liquidated before the maturity period, invites penalty wherein debt fund can be liquidated at any time.
Tax Efficiency: The income from FD is taxed (subject to few caveats) at 33.5 percent, for someone in highest tax bracket. In debt mutual funds, if held beyond three years, only LTCG tax applies, which is 20 percent of the income accrued, with indexation benefits.
Drawbacks: Debt funds also have their drawbacks like being subject to risks as we have already discussed and chances of losing part or the entire principal amount. These drawbacks can be obviated by taking precautions enumerated in the previous musing.
We now look at Recurring Deposits or RD. Starting investment in debt fund by SIP is better than RD in a bank. One gets all the benefits of the market as also benefits from the power of compounding.
Next is the savings bank account where we keep our ‘breathing fund’ (remember the musing?) and most of our routine expenditure money. This money, which can be a fairly large amount, can be parked in liquid or other short duration funds. We can earn returns far greater than 3 to 4 percent as is being given by savings bank account.