BONDS AND THEIR INTEREST IN "INTEREST RATES"
By Ruma Dubey
The way bonds are scheduled to flood the markets before 17th of September, the RBI Credit Policy day, shows how expectations play a decisive role. Markets play up to each and every expectation, like a drowning man clutching the straw and companies are planning to cash-in on the same sentiment.
If, (this is a big “IF”) RBI cuts the rates on 17th, naturally, bond prices will go up. Bonds or debenture prices are inversely proportional to interest rates – when rates go down, bond prices rise. One thing seems certain now – rates will not be hiked further. When rates go up, Fixed Deposits (FDs) make more sense and bonds are a big no-no as their value only goes down with every rate hike. Thus when the rate cycle is set for a downturn, maybe not on 17th but surely in the months to come, it is the perfect time to buy bonds and less of FDs. Especially for those in the 30% tax bracket, investment in bonds at this juncture makes perfect sense.
Most people find this entire calculation of yield from bonds vis-à-vis the interest rate very difficult to grasp and like Buffett says, never invest in something which you do not understand. So to take advantage of the oncoming ‘season’ of bonds or Non Convertible Debentures, here is a simple and lucid way in which one can calculate the returns and understand why interest rates and bond rates are inversely proportional.
Suppose Ramesh has invested Rs.1,00,000 in bonds and he has been promised an interest rate of 10% on the bonds but soon interest rate falls to 9%. This means he is getting Rs.10,000 as interest on these bonds while thanks to the fall in interest rates, it would have been earned him Rs.9000 if invested later.
Now Suresh, in this 9% interest regime wants to buy the 10% bonds from Ramesh; so what will be the price at which Ramesh will sell? That in short is the co-relation between bonds and interest rate. So Suresh, if he invests now, will earn Rs.109000 at the end of year while Ramesh will earn Rs.1,10,000. And if Suresh wants the same bonds which Ramesh has, he has to pay 1,10,000 x 1,00,000 / 1,09,000 = 1,00,917.43. Thus to get the bonds today worth Rs.1,10,000, Suresh will have to pay Ramesh Rs.100917.43, a premium of Rs.917.43.
But suppose the interest rates had gone up to 11%? At 11%, his Rs.1,00,000 bonds will earn him an interest of Rs.11,000 while Ramesh is holding bonds which earn Rs.10,000. So if Ramesh wants to sell these bonds to Suresh, it will be sold at 1,10,100 x 1,00,000/1,11,000 = 99,099.10. Thus to get the bonds worth Rs.1,00,000, Suresh will have to pay Ramesh Rs.99,099.10; approximately Rs.901.
And this simple example explains why there is a rush to buy up bonds when interest rates fall. Around Rs.2000 crore worth of bonds is scheduled before 17th Sept. The NCD issue of India Infoline has already opened ( details can be found in our New Issue Analysis section) and it aims to raise Rs.500 crore. Then there is SREI Infrastructure Finance which aims to raise Rs.150 crore and Rs.500 crore each is expected to be raised by NCDs from Religare Finvest, Muthoot Finance and Shriram City Union Finance. 5 NCD issues within this fortnight and that too in a very volatile market scenario!
Our New Issue Analysis section will explain the merits and demerits of each and every of these issues but largely, while investing, pay attention to - quality of the company, credit rating, returns after tax, whether or not the bonds are liquid enough – can you sell when listed? But more than looking at NCDs as a trading instrument look at them as an long term investment option and go for longer tenures because we are now at a falling interest rate cycle and longer tenure will earn you more.