For many investors, 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 at least understand the basics.
A bond's coupon is the annual interest rate paid by the issuer of the bond. It can be paid out quarterly, semi-annually or annually on individual bonds. The coupon is always tied to a bond's face value.
Say you invest Rs 5,000 in a 6-year bond paying a coupon rate of 5% per year, semi-annually. Over the tenure of the bond, you will receive 12 coupon payments of Rs 125 each.
Bonds that don't make regular interest payments are called zero-coupon bonds, which means they pay no interest. Investors buy such bonds at a discount to the face value of the bond and are paid the face value when the bond matures.
Yield differs from the coupon rate.
Let’s say a bond has a face value of Rs 100 with an 8% coupon rate. This means that the investor will earn Rs 8 per annum on each bond he invests in.
Once the bond is issued, however, it trades in the open market – meaning that its price will fluctuate each business day for its entire life. 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 8. 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 80.
Now let’s say interest rates fall to 6%. Again, the investor will continue to earn Rs 8. This time the price of the bond will have to go up to Rs 133.
There are two aspects to note from this. 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.
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 10%, it means that if the portfolio remains constant until all the holdings mature, then the return to the investor would be 10%. However, the YTM does not remain constant as the portfolios are actively managed by the fund manager.
It 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.
To further elaborate the point that bond prices and interest rates are inversely related, let us look at Modified Duration, or MD.
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 4.50. What this indicates is that the price of the bond will decrease by 4.50% 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.
Since modified duration of a portfolio takes into account all the debt instruments, it will change with regard to the composition of the portfolio.
