2009 shall be the year of The Bond (market). Bonds have already started off the upward journey on the face of lackadaisical interest in equities and a speculative opportunity arising out of yields going up significantly in the past few months. Expected downgrades and fears of default had pushed up bond yields to high levels in the past few months. Added was fact that they yield on the benchmark 10 year Gsec paper, had climbed to a high of 9.5% in late July 08.
A bond or fixed income security is an instrument issued by a borrower with a certain interest rate (referred to as coupon rate), and a fixed maturity. Bonds are thus fixed obligations to return principal and make fixed tenor payments of interest to the holder of the bond. Long duration (more than one year) Bonds issued by the Government are often referred to as G-Secs or Gilts. Gilts are supposed to be the safest instruments and carry zero credit risk. Bonds are often tradable securities which gives rise to an opportunity to benefit from the change in prices of these bonds. Bonds and fixed income securities are sensitive to various factors. Interest rates prevailing in the economy, risk premiums attached to different securities, often measured by their credit rating, and factors affecting demand and supply of bonds decide bond prices. Some other factors like liquidity risk also play a part. Lets consider how each of these affects bond prices. Interest Rate Risk: Bond prices are inversely related to the interest rates prevailing in the economy. Lets consider a scenario where you make a FD with a bank at 8% pa for 5 years. After 6 months you realize that deposit rates have risen to 10%. A rational investor would break the old FD and tell the bank to make a new one at 10%. Now suppose instead of a bank FD you were really holding a tradable bond, with interest rates going up to 10% the 8% bond has become less attractive. This would reflect in the price of the bond, which would fall to a price so that the 8% coupon would work out to a yield of 10%. Thus the new price would be 8%/X = 10%. The new price thus would be Rs 80 representing a fall of Rs 20 from the original price of Rs 100. The same logic would apply if the interest rates fall, bonds carrying a higher rate become more attractive and their price would go up to come in line with the higher yields prevalent in the bond market. Credit Risk: This simply put is the risk of default on the borrowings. Bonds issued by companies not perceived to be very safe would be issued at a lower price, thus making the yield attractive to investors. A Rs 100 bond with a coupon of 8% thus may be issued at Rs 96 thus making the yield 12% to the investor. Now if the outlook on this company falls further ie suppose its bonds are downgraded by the rating agencies, the prices would fall further (and yields would rise), thus resulting in a loss for the investor. Similarly the reverse would happen if there is a upgrade in the rating of the bond. Credit risk is sometimes reflected in the spread between government bonds and bonds issued by companies. So a widening yield spread between the benchmark 10 year G-Sec and AAA Corporate paper means that generally the markets believe there is a significant credit risk in corporates bonds. Liquidity Risk: Bonds are traded in the secondary market which is not very deep. While G-Secs are actively traded securities, PSU and corporate securities are sometimes not actively traded. Liquidity risk represents the risk arising out of not being able to sell these securities when required. The holder of a bond may thus be forced to liquidate the security at a discount leading to a loss. Some other factors affect the demand and supply of bonds and thus their prices. Fresh government borrowing represented by a higher supply of government bonds, changes in SLR ratio of banks, which is the percentage of deposits of banks that has to be held in Government securities and the speculative interest in bonds are some other factors affecting prices. The last few moths of 2008 saw major volatility in the bond markets. In July 2008 the benchmark 10 year G-Sec (8.24% GOI, 2018) yield rose to a 9.5% in the face of rising interest rates in the economy. As the government's focus shifts from controlling inflation by increasing interest rates to one of growth orientation marked by reducing interest rates, bond yields started falling. The 10 year G-Sec yield thus started it's downward journey and reached a low of 5.44% in December returning huge profits to holders of these bonds. The year 2009 also holds promise for the bond market. Lack of interest in equities would make it difficult to raise fresh capital from equities. Corporates would be forced to look at the debt market for their needs. Mutual Funds would become active and there are signs already, as the retail investor look towards options other than equity. My opinion is that the rally has only just begun and would continue to hold promise for better part of next year. What may not happen in a hurry is the yield contraction between corporate and government paper. There seems to be a wide spread opinion that all may not be well in the corporate bond market and some defaults are likely in the next quarter. Although the current spreads seem to have factored in the risk, actual defaults may further dampen spirits leading to a further expansion in spreads. While later in the year the fears may subside, the spread contraction theory may take a little while to take off. Personally I would prefer bond funds that hold government and PSU paper only. -- Posted By finpower to FinPower<http://finpower.blogspot.com/2009/01/year-of-bond.html>at 1/05/2009 04:13:00 AM --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups ""GLOBAL SPECULATORS"" group. 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