Saturday, 22 September 2012

[www.keralites.net] Buying Bonds from Secondary Market – Clarification

 

 
 
Dear Krishnakumar,
 
As you know, a stock represents ownership, and it's worth only what somebody else is willing to pay for it or company itself buy back form you(this will happen very rarely) . But a bond is a promise to pay you back on a specified date in the future, called the maturity date, as well as interest payments in most of the cases twice a year in the meantime. Therefore, if your priority is to make as much money as you can because you believe in a company's prospects, you should buy the stock. But if your priority is to be repaid, with interest, and to minimize the risk of losing your principal, you should buy a bond.
 
Eg.   Mr. X comes to you and asks for help raising money to build his small software company. He offers you two choices: Loan him  Rs. 10,000,000.00, and he  promised to pay it back with interest after five years, or give me Rs. 10,000,000.00, and I'll give you 1,000,000 shares of stock in my company – but no promises that you'll ever get back your Rs. 10,000,000.00.  This is the basic difference between bond and shares.
 
 
One thing every bond investor should understand is how prices fluctuate on the secondary market. In a nutshell, bond prices go up and down in the opposite direction from interest rates. Here's a simple example. Suppose a company issues  Rs. 1,000 bond that pays 8 percent interest, with payments of Rs. 40 every six months. Then imagine that one year later, interest rates have risen very sharply and new bonds of comparable quality must pay 10 percent, or Rs. 50 every six months, in order to attract buyers.
 
Nothing has changed about the 8 percent bond, which still pays Rs. 40 every six months. The company will still pay back the Rs. 1,000 at maturity. But now, investors expect to get a higher yield, and they won't pay the face value of Rs. 1,000 for an 8 percent bond when they can buy a new one that pays 10 percent. If you own the year-old bond and want to sell it, you'll have to sell it at a discount that makes it competitive. Mathematically, the 8 percent bond's interest payments would have a current yield of 10 percent only if that bond could be bought for Rs. 800, so investors are likely to offer you something in that neighborhood for that bond. The "price" of the bond has just fallen by 20 percent, and an investor who sells it in the secondary market will take a big loss.
 
On the other hand, if you keep that bond you'll still get your Rs. 40 every six months and your Rs. 1,000 at maturity. This leads to a rule of thumb that says you don't lose money on a bond if you hold it to maturity.
 
But now let's see what would happen if interest rates changed the other way and new bonds were being issued at only 6 percent. What do you think happens to the secondary market value of the 8 percent bond? Right! Those 8 percent bonds are now worth more. Mathematically, they should sell for Rs. 1,333.33 in order to produce a 6 percent current yield. The investor who sells that 8 percent bond at this price makes a nice profit.
 
But there's one little wrinkle in this scenario. The investor who makes that profit has to reinvest the money. And with new bonds paying only 6 percent, the whole Rs. 1,333.33 must be reinvested in order to achieve the same yield as before. That doesn't leave a thing for paying the capital gains tax on that profit of Rs. 333.33.
 
Why Buy Bonds
 
Some people buy bonds in order to speculate on the future course of interest rates. If you believe strongly that interest rates will fall, and if you are right, you can make money by buying bonds and selling them later. But this activity is speculation, not investment, because the future direction of interest rates is never certain, and if rates go up instead of down, you can lose money instead of make it.
 
Most bond investments are made for one (or a combination) of three reasons: liquidity, stability and income.
 
Bonds provide liquidity because they allow you to get your money back on short notice with relatively little risk of losing your principal. This is even more true of bond-like instruments including money-market funds, certificates of deposit and checking accounts.
 
Bonds provide stability to a portfolio because they are normally less volatile than stocks.
 
 
And of course bonds provide income, usually twice a year. Some investors like to structure their portfolios so the interest checks come in every month or every quarter, providing a reliable source for their living expenses. If a bond portfolio gives you an assured regular income that meets your needs, you don't need to pay much attention to the fluctuations in the prices of those bonds on the secondary market. Similarly, if you own your home and it provides the living space you need, you don't have to pay much attention to its current market value.
 
You have to be very careful in selecting the bonds.  You need to see the ratings of the bond from a reputed Credit Rating Agency.   If you buy low rated/junk bonds sometimes you may not get the coupons on time and there is every chance to lose your capital.
 
Best Regards
Prakash Nair
 
 


From: Krishnakumar B <bkkumar56@gmail.com>
To: Keralites@yahoogroups.com; P Nair <pnair1966@yahoo.com>
Sent: Saturday, September 22, 2012 9:38 AM
Subject: Re: [www.keralites.net] Buying Bonds from Secondary Market – Go through the checklist
Dear P Nair,My sincere thanks for the information. However I will be happy to know some more information regarding the gains against stocks. The bond market calculations are not easy to understand.If you can give some more information with examples, it will be highly appreciated. With regardsKrishnakumar
On Fri, Sep 21, 2012 at 12:43 AM, P Nair <pnair1966@yahoo.com> wrote:
 
 
As trading in bonds catches up in India, you should gear up for gaining by focusing on the following important elements of the game
 
Bond markets have always been shallow for retail investors in India. In spite of the fact that bond (debt) markets globally are two-thirds of total securities traded, in India in a stock exchange like NSE total traded amount for bonds in the capital market segment is hardly Rs850 crore compared to an average volume of Rs1.25 lakh crore in the derivatives segment and around Rs15,000 crore in the cash market. CCIL's NDS-OM segment has a huge volume in debt market but this market is largely accessed by institutional investors.
 
However, things have started changing gradually. With more and more bond offers hitting the market and getting listed on stock exchanges, the opportunity for retail investors has started increasing in this segment. IDBI has started a portal called Samrridhi which gives opportunity to retail investors to buy government bonds from the secondary market. In every auction of dated securities, a maximum of 5% of the notified amount is reserved for non-competitive bids by Reserve Bank of India (RBI) in which retail investors can participate and buy bonds in primary market
 
 These bonds can be subsequently sold in secondary markets.
While the opportunity in bonds market continue to increase and generate prospects of decent returns, it is important to be educated to buy these bonds. A wrong selection of bonds can be as risky as a wrong selection of stocks. Hence due care needs to be taken to buy bonds from the secondary market. Some of the most important factors to be considered while buying the bonds in secondary markets are as follows:
 
Understand clean price and dirty price: Bonds trade at clean price and dirty price in different markets. In India, bonds trade at dirty price in the NSE corporate segment. Dirty price is the price of a bond with accrued interest. This means that a bond trading in the NSE corporate segment has accrued interest included in it. Accrued interest is the interest that has got accrued on a bond from last coupon payment date. As a buyer of the bond, you are supposed to pay accrued interest to the seller of bond.
In CCIL NDS-OM segment on the other hand, bonds are traded at clean price and when you buy the bonds you pay clean price plus the accrued interest separately. So when you see the price quoted of a bond on CCIL NDS-OM, do not get misguided by the lower price as it does not include accrued interest. So the dealer through whom you buy these bonds will ask you to pay accrued interest separately and hence your effective cost of the bond will be accrued interest plus clean price which is equal to dirty price.
 
Coupon of a bond is not your return: If a bond offers a coupon of say 10% and you decide to buy this bond on basis of the coupon, you may end up making a wrong decision. In secondary market, you should look at the yield of the bond. Yield is your return and not the coupon. A 10% coupon bond may give 8% return only, if the bond price has gone up since the time it was issued, while an 8% coupon bond may end up giving 10% return if the bond price has fallen since the time the bond was issued. In bond market, an inverse relationship between the bond price and the rate of interest exists. Thus, while deciding to buy a bond from the secondary market, look at the price of the bond and its yield.
 
Map the maturity of a bond to your investment needs: Bonds are available with different maturity periods in the bond market. Very few of us would be aware of the fact that bonds with 30 years maturity are available in the market today. The RBI had issued a 2041 GOI bond with 8.83% coupon which currently trades in the market. This bond still has 30 years left for maturity which means that you can continue to receive 8.83% coupon on a semi-annual basis for this bond for next thirty years. However, as mentioned above, the yield of this bond is lower than the coupon. Some bonds are maturing just next year i.e. 2013. As an investor, you need to map the investment needs with bonds maturity and returns. It is important to note that bonds with higher maturity are impacted more by the interest rate changes both on upside side as well as downside. This means high-maturity bonds are more volatile than low-maturity bonds.
 
Look at rate of interest pattern in the economy (yield curve): Though yield curve is a hard nut to crack, as a retail investor you can look at trends in the rate of interest. In a falling interest rate environment, bond prices go up and you can benefit by selling bonds that you hold. So the ideal time to buy bonds from the secondary market is when rate of interest has peaked. For an investor holding bond till maturity, the change in rate of interest does not matter.

A high coupon bond may command low price: You will be surprised to know that Muthoot Finance N6 series bond which was issued at a face value of Rs1,000 and coupon of 12.25%, currently trades at around Rs960 while a mere 8.2% coupon bond of NHAI trades at a price of above Rs1,040. This price difference is important to understand. The bonds trade at different prices because of the risk perception of the market about these bonds. So a person who had bought Muthoot Finance bond from the primary market will make a loss if he sells the bond in the secondary market now while a NHAI bond holder will make gains while selling bonds in the secondary market.
As a retail investor it is important to understand and invest in bond market. Bond markets are low risk investments compared to equity but the risks of the bonds are good enough to cause loss to a small investor.
Source :MLF
Best Regards
Prakash Nair 
www.keralites.net
--   കൃഷ്ണകുമാര്‍ (സമ,ബറോഡ)

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