Fixed Income Securities

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The world of G-sec’s, money market instruments and Bond markets cab be very esoteric. This article explains all and opens up and avenue of investments for superior to bank Fixed Deposits.

 

Constant fall in interest rates have brought about a distinct change in asset allocation principles thus forcing all constituents of the economy to look at the breadth and depth of the Debt market . The Indian Government has been proactive now in allowing even the retail participants in a select way to benefit from the trades.

 

Fixed Income securities play an important role in any portfolio of investments as they provide stable (fixed) returns over the life of the instrument. As a class of investments, they are perceived to be less risky than equity or quasi-equity products. However, the popular perception that these are SAFE options is true only in some respects. Any market investment cannot be free of risk. Equity investments are more volatile but historically have outperformed bond investments in the long run.

 

The Indian Debt market consists of two broad categories namely Govt securities (G-sec’s) market and Bond market. Near substitutes for money, in the form of Money Market instruments is yet another form.

 

While G-Sec’s and Treasury Bills are issued by RBI on behalf of the Central or State Govt are widely prevalent, totally guaranteed unconditionally and irrevocably by the Govt and are denoted as dated securities with a fixed coupon (interest) rate and date of maturity , the Bonds are issued by Financial Institutions,PSU’s,Top Corporates and can even be Govt guaranteed . Ratings by various agencies provide comfort to the extent of safe return of Principal and Interest on these Bonds. The underlying security of these Bonds lie in the form of free mortgagable assets. While the Govt issuances can be for a long period of even 25 years, the Corporate Bonds are normally for shorter horizons only.

 

Money Market Instruments usually assign the form of Call Money, Certificates of Deposit(CD), Commmercial Paper (CP), etc.

 

G-secs, being totally free of risk is entitled for a premium in the form of spreads (difference between a G-Sec and a Bond of a similar tenure). Since the no. of G-Sec issuances are large , usually a 10 year G-sec paper is considered as a benchmark for the purpose of understanding the broad market movements .

 

The Participants in Money and Debt markets can be the Banks,Financial Institutions, Primary Dealers, Companies, Mutual Funds, State Govt’s, Trusts, RBI, Central Govt, Individuals, etc.

 

The Bonds and G-secs ,once issued and uptil the date of maturity have a price element on which the trades are put through. The prices can vary depending on a host of factors and can be sentiment driven too.

 

Before we get to know what drives the debt market and the factors which play a significant role in adjusting the prices let us look at the various options and the transaction costs and the risks associated with the market .

 

Individuals thus far were restricted entry into this domain due to the deal sizes which were to be a minimum of about Rs.5.crores . It is advisable that individuals,unless one is very well acquainted with the nuances of the G-secs,takes part through the MF route to ensure convenience in management and thereby avoiding higher transaction costs .

 

The various risks associated with the G-Sec and Bond market can be the following :

 

Credit Risk- Typically, credit risk is looked at vis-à-vis sovereign (read Government of India) securities. Sovereign bonds are known as risk-free or zero-risk (read credit risk) whereby the principal is guaranteed by the Central Government at maturity. For investors who would like to eschew credit risk, Gilt Funds would be an ideal investment tool. Bond Funds, on the other hand, attempt a mix of securities with normally a higher percentage allocated to corporate bonds. The amount of credit risk in the portfolio can be measured by studying the percentage of AAA or AA in the portfolio and the percentage of low-rated or unrated securities in the portfolio.

 

Interest Rate Risk-Even though “Fixed Income” products provide “Fixed” return over the life of the instrument, the actual “held period return” on any security could differ based on the market level of interest rates at the time of exit. The fact that held period return could be different than the fixed return locked into, gives rise to Interest rate risk for open ended debt schemes which provide any time liquidity to investors. Interest rate risk can be viewed as a combination of market risk (arising out of movement in yields), liquidity risk (arising out of the ease of exit in specific security) and ALM risk (the ease of exit for the fund). These risks are present in all investments in Fixed Income securities, even though the degree and combinations of the risk elements could be different between different securities. Like wise, in most of these risks, the nature of risk does not change with the investment vehicle. Even in case of so called risk-free sovereign securities, interest risk, liquidity risk and ALM risk cannot be assumed away.

 

Market Risk: In respect of market risk, there are technical tools available to manage the risk. These are Portfolio duration and Value at Risk (VaR). VaR tries to measure, in a scientific manner, the amount of loss that a portfolio could suffer over a given frame of time. A Portfolio of 30days and VaR of 5% would imply that the risk embedded in the portfolio is that it can lose 5% over a 30-day time frame. This can also be expressed in absolute terms. Value at risk is considered as superior method, but is yet to be widely adopted in India, as it requires large historical data to enable better sampling and simulation. The key characteristic that gives a measure of the interest rate sensitivity of a bond is duration. There are two different measures of duration, Macaulay Duration and Modified Duration. Macaulay Duration has a unit of time ie months, years etc. whereas Modified Duration does not have any unit and is just a number. While both macaulay duration and modified duration are correlated, modified duration is more elegant and meaningful because it directly gives the approximate percentage price change bond for a one percent change in interest rate.

 

Modified Duration (MD) tries to estimate the price sensitivity of a fixed income security to changes in yield. For example, a portfolio MD of 1.5 would imply that, for a 1% change in yield, portfolio value would move 1.5% in the opposite direction. Also, using it for a portfolio has an underlying assumption of parallel movements in yields. . Typically, a low MD would mean lower interest risk and vice versa.

 

Liquidity & ALM Risk: The management of liquidity risk is done through holding liquid securities. However, the liquidity of instruments (ease with which one can get a narrow two-way price for market lots) keeps changing and hence continuous monitoring of the portfolio is required. Traded volumes are usually a proxy for liquidity of an instrument and these tend to be higher in benchmark securities, A portfolio with high a percentage of these securities can be said to be more liquid.

 

Liquid Funds & Risk- Even though liquid funds are not immune to the above risks, the degree of the risk is perceived to be low since most of the liquid funds invest in overnight and very short dated instruments. The credit risk is also considered low since most active paper in the short end of the market, is issued by top rated corporates. Likewise, active borrowers in the overnight call money market are foreign banks, private banks and primary dealers. Even though portfolio MD can be calculated for Liquid Funds, as most of these are designed for capital preservation, the average number of days of maturity would be sufficient enough to provide a satisfactory risk parameter.

 

It is in connection to the risks involved that Corporates and Individuals think alike and take the professional fund management (investment manager) practices evolved by Mutual Funds (MF’s). The Fixed Income products of MF’s are designed to provide returns to investors through investments in debt securities. The different schemes within this category are aimed at investing in various classes of debt instruments viz., money market instruments, corporate and government securities of various tenors. The objectives of the various schemes are as following :

 

Bond Fund-Long Term Plan: To generate stable and consistent returns at controlled levels of risk through investments in the broad category of debt securities.

 

Bond Fund - Short Term Plan : To generate stable and consistent returns through investments in short term debt securities.

 

Liquid Fund : To generate optimal returns consistent with short term liquidity.

 

Gilt Fund: To generate credit-risk free returns through investments in government securities of long or short maturities .

 

Usually a MF stresses on Investment Philosophy to provide stable returns at controlled risk levels. The critical elements of this philosophy are (i) optimal returns (ii) appreciation of market risks and (iii) combining the above two to deliver pragmatic performance.

 

Investment Strategy: In attempting to deliver optimal returns at controlled risk levels, the strategy is to maintain an ideal balance among various portfolio considerations viz., Portfolio Yield, Liquidity, Credit risk profile and Interest risk profile; keeping in view the current and expected market conditions.

 

Investment Process:The investment management process uses a structured approach encompassing an evaluation of factors affecting interest rates.

 

Broadly, these factors are :

 

Real economic factors such as Economic Growth, Credit, Investment Demand, Revenue Deficit, Trade Deficit, etc

 

1. Monetary Variables such as Money Supply growth, Inflation, Oil Prices, Balance of Payments, Exchange Value of Rupee ,etc

 

2. Policy Variables such as Monetary policy & Stance, Fiscal policy & Fiscal Deficit, Structural Issues such as administered rates, reform process etc

 

3. Short Term Factors

 

4. Shape and Structure of yield curve, Corporate spreads, System Liquidity, Market sentiment, etc

 

5. External events

 

The investment managers are required to continuously evaluate market conditions keeping in view all these variables and their expected impact on interest rates. The investment process emphasises delivery of labeled objective.

 
 

 

                   Impact of debt markets on certain variables
 

Variable

Status

Short term

Medium Long Term

Economic growth

Improved

Neutral

Neutral

Credit/Investment demand

Weak

Positive

Neutral

Monetary policy

Soft

Positive

Neutral

Inflation

Low

Positive

Positive

Balance of payments

Comfortable

Positive

Positive

Liquidity in System

Comfortable

Neutral

Neutral

Fiscal deficit

High

Negative

Negative

External events

Rating risk ?

Negative

Negative

Structural issues

Improving ?

Positive

Positive

Risk Management :-

 

Credit Risk: The MF’s attempts to maintain a high percentage of AAA securities or equivalent in the portfolio. In the Bond Fund, normally 50-60% of the portfolio is maintained in corporate bonds and 25-50% in gilts with balance being money market and other cash equivalent instruments. However, depending on the market conditions the actual percentages could differ slightly from time to time.

 

Interest Rate Risk: As mentioned above, the MF’s are required to continuously monitor the market conditions. The portfolios are managed actively with adjustments carried out in line with the market sentiments and expected movements in interest rates.

 

Portfolio Modified Duration (PMD) is used by the managers as one of the measures to ascertain the interest rate risk embedded in the portfolio.

 

Liquidity Risk: In the current context of sharp polarisation of yields between benchmark and other securities coupled with high market volatility, the percentage of liquid/ benchmark securities in the portfolio is important. This percentage would also provide a clue as to the quality of the portfolio since the benchmark securities are the ones for which prices are readily available.

 

Comparison of Fixed Deposit of Banks and Companies with
Debt and Gilt funds* as on 31/12/02

 
 

Banks

Companies

Debt fund

Gilt fund

2 year

5.25

6.3

18.16

Not Available

1year

4.75

6.05

16.5

20.17

6 months

4

Not Available

20.18

12.65

 

 

Other advantages of investing in a MF – No penalty clause when liquidity is the need of the hour unlike bank deposits. Bank deposits involve TDS (tax deduction at source) when interests exceed Rs.5000 in a year while. Dividends on debts and Gilts MF involve TDS only when the Quantum exceeds Rs.2500 per branch per scheme

 

In my own opinion, bond funds would gain popularity because of the healthy past experience and relative to other opportunities; they are relatively low on risk and performance enhancement over fixed deposits. MF’s have also brought features like systematic withdrawal plans, which would reduce tax incidences. Periodic investments like recurring deposits in banks can be made in MFs in a unique manner called systematic investment plan, which provide buying opportunities at varying prices thus entitling an investor and ‘average price’. However, the only disadvantage in a MF is that return in not assured.

 

The yield and price of Bonds have an inverse relationship and therefore Rate cuts generally aid in better prices. Whereas, interest rate cuts in the economy bring with them a drop in interest rates on fixed deposits, usually in the case of debt funds the impact is to the contrary, i.e, the earnings potential improves. This makes the debt and gilt funds improve substantially. The rate cuts over the last one and half years have made debt funds deliver returns over 15% p.a, which is likely to undergo few corrections herefafter.

 

Even from a world wide context,Asian bonds outperformed all major asset classes last year . Asian dollar denominated bonds returned 15percent to investors in 2002 , compared to 7.1 percent and 13.1 percent in the U.S BBB-rated Corpoartes and emerging markets respectively according to data published from JP Morgan. This strong performance contrasts with about 9.7 percent fall in 2002 in the pan-region Morgan Stanley Capital International (MSCI) Asia Pacific Free share index and about 20 percent plunge in MSCI World Free Index . Bond Funds attarcated net inflows of $731.9 million,or 17.4 percent of total industry sales in the first ten months of 2002 , which in the Indian context is over 75 percent . Overtime,investors passion for guarnateed products(which initially look attaractive) would wane further as investors realise their money is locked in for a long time with limited upside potential

 

In conclusion, Bond funds emerge as a front-runner vis-à-vis other financial assets in its class and are considered suitable from an asset allocation point of view and also to provide liquidity, safety and convenience in management.

 

The views expressed by the author are his own and do not represent that of his Co.

 

To suit one’s risk appetite and to ensure meeting of financial goals, it is however advisable that all investors seek investment opinions from advisors/distributors. For feedback send email to ravindranl1@businessgyan.com.

 

(The author is L.RAVINDRAN V.P and Head-South &East, IL&FS Asset Management Co Ltd, which manage Rs.1365.crores as on Dec31st’2002 across 5 schemes in debt and 3 schemes in equity.)

 

 

Issue BG23 Feb03