Mutual Funds

What makes bonds tick

Murthy Nagarajan | Updated on May 25, 2014

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Can bonds give you capital gains? How are bond prices linked to rates? A primer



There’s plenty of gyan on stock markets and how to invest in them. But do you really understand bonds?

Here’s what you need to know.

Income sources

Bonds which generate fixed income may be issued by Governments (state and central), companies, banks and financial institutions. Bonds generate returns through three sources. First is the coupon income. This is the periodic interest that the bond pays throughout its term. Unlike equities (where the dividend income tends to fluctuate), bonds generate steady income.

Second is the income generated from re-investing this interest income received from the bond.

Third is the capital gain/loss, which is the increase or decrease in bond prices caused by a change in the interest rates. When market interest rates fall, bond prices move up, leading to capital gains.

Conversely, when interest rates rise, bond prices fall, resulting in a loss. Bonds can be sold before maturity and gain from market movements. This is what distinguishes a market-traded bond from other fixed income instruments such as fixed deposits, postal savings and retirement savings such as PF and PPF.

Returns from fixed income instruments and bonds are sensitive to three factors. First, change in key interest rates impacts bond prices in the market.

An increase or decrease in the key interest rates can cause a fall or rise in bond prices and its returns. The returns of securities with a longer maturity period are more sensitive to the interest rate changes.

The second is inflation. Continued higher inflation also leads to higher interest rates, further lowering bond prices.

Third, bonds other than those issued/guaranteed by the Central government are exposed to the risk of default by the borrower (failure to repay the interest and principal).

The higher the perceived default risk from an instrument, the higher would be the relative yield on that bond.

Fourth, other economic indicators such as growth, fiscal deficit, currency and crude oil prices also have an impact on bond returns. For instance, a weak rupee, rising oil prices and widening deficit may hurt bond returns. But expectation of weak economic growth is actually positive for bonds, as the central bank may cut interest rates, sparking a rally in bond prices.

Why invest in bonds

In India, the retail investor is largely exposed to fixed income instruments through government-run assured return schemes such as NSC, PPF and of course bank fixed deposits.

Unlike equities, bond markets are institutional in nature and thus have had minimal direct retail participation.

But the last three-five years have seen many companies raise money by public issuances of bonds, particularly tax-free bonds. With general interest rates remaining high, the coupon rates on these tax-free bonds have made them an attractive option. For investors in the 30 per cent tax bracket, tax-free coupon rates of 8.5-9 per cent are more attractive than fixed deposits. Given the strong demand, these bonds are currently trading at significant premiums in the secondary market. Despite their having maturity of over 10 years, investor interest indicates appetite for appropriately priced and safe bond issuances.

Debt mutual fund schemes that invest in bonds are also a good asset allocation bet.

(The writer is Head of Fixed Income, Quantum Mutual Fund)

Published on May 25, 2014

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