The basic terms regarding debt investments

Like in food we need all the variants (i.e. Rotis, vegetables, pulses, salads etc.) so as to get all the necessary things for our developments similarly for investments also we should have all type of securities i.e. equity, debt, gold real estate so that we can get the best out of it. Although debt securities are viewed as the least interesting component of a portfolio, lacking the vitality of stocks and equity instruments. But it performs a useful function in a portfolio, and it would be sensible for investors to have basic understanding of them, in this post we are discussing the basics of debt securities.

Yield  

A Debenture / bond's coupon is the annual interest rate paid by the issuer of the security. It can be paid out by various frequency depending upon the terms of the security i.e. quarterly, semi-annually or annually. The coupon is always linked to a bond's face value.

Say you invest Rs 10,000 in a 5-year bond paying a coupon rate of 8% per year, semi-annually. In this case, you will receive 10 coupon payments of Rs 400 each over the tenure of the bond.

Bonds that don't make regular interest payments are called zero-coupon bonds, in which they don’t pay interest in between the tenure of the bonds. Investors buy such bonds at a discount to the face value of the bond and are paid the face value when the bond matures.

Say we invest Rs 10,000 Face Value bond having maturity after 5-year bond at a discounted value of Rs.7000. In this case the annualised yield comes to approximate 7.40%.

Companies also issue floating rate bonds where the interest rate is linked with some benchmark rates and it fluctuates as the benchmark rate moves.

Yield is different from the coupon rate.

Let’s say a bond has a face value of Rs 100 with and 9% coupon rate. This means that the investor will earn Rs 9 per annum on each bond he invests in.

Once the bond is issued, after that, it trades in the open market – meaning that its price will fluctuate each business day for its entire life depending upon various economic and market related factors. As interest rates in the economy rise and fall and demand for the bonds moves up and down, it will impact the price of the bond.

Let’s assume interest rates rise to 10%. Even so, the investor will continue to earn Rs 9. That is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 90 {9/90= 10%}.

Now let’s say interest rates fall to 8%. Again, the investor will continue to earn Rs 9. This time the price of the bond will have to go up to Rs 111.29 (approx.) {9/111.29= 8%}.

This explains two aspects from the above examples.

·     One is that the yield is not fixed but fluctuates to changes in the interest rate.

·     Secondly, the price of the bond moves inversely to interest rates. It moves to maintain a level where it will attract buyers.

Yield to Maturity

The Yield to Maturity, or YTM, of a debt fund portfolio is the rate of return an investor could expect if all the securities in the portfolio are held until maturity. 

For instance, if a debt fund has a YTM of 9%, it means that if the portfolio remains constant until all the holdings mature, then the return to the investor would be 9% (annualised). This is generally applicable to Fixed Maturity Plans of Mutual funds.

However, in the practical world and especially for open ended mutual funds the YTM does not remain constant as the portfolios are actively managed by the fund manager.

YTM broadly indicates to the investor the kind of returns could be expected. But it is not a definite indicator since returns may vary due mark-to-market valuations or changes in the portfolio.

Modified Duration

Modified Duration, or MD is the number which can further elaborate the point that bond prices and interest rates are inversely related.

As explained earlier, if there is a rise in interest rates then there is a fall in the price of the bond. If there is a fall in interest rates, then the price of bond will rise.

MD is the change in the value a debt security in response to the change in interest rates. So let’s say the MD of the bond is 4. Then it indicates that the price of the bond will decrease by 4% with a 1% (100 basis point, or bps) increase in interest rates.

This provides a fair indication of a bond’s sensitivity to a change in interest rates. The higher the duration, the more volatility the bond exhibits with a change in interest rates.

When we consider the modified duration of a portfolio, It means that it takes into account all the debt instruments and will change with regard to the composition of the portfolio.

Credit Rating

All bonds/debentures are not equal and it is measured by the credit rating of the issuer company. There are five credit rating agencies approved by SEBI to rate the companies. The top rating for any security is AAA and it goes down to AA, A, BBB and so on. Generally the investors’ grade rating is upto BBB.

Higher the rating means stronger the issuer company which indicates lower the risk so the interest rate offered by the company will be lower as compared to the lower rated companies. Sovereign bonds issued by the government are generally called as risk free securities and considered as benchmark while comparing the risk return trade-off with other issuers.