Understanding bonds and debt funds through a simple comparison with FDs
Comparison of Bonds & Debts Funds With FDs
ORO explains how bonds and debt funds work by using the familiar example of FDs.
Bond Fact#1: If a bond is held to maturity, it is similar to FD in the sense that the payoff is known in advance.
Most investors are familiar with the payout structure of FDs. Bonds are similar to FDs in 3 major ways:
1. There is a definite maturity period. It is not a perpetual instrument like equity.
2. Bonds pay out regular interest payments, the amount and schedule of which is known in advance. Total interest paid out in the year = coupon rate* face value and
3. Investor gets a known lump sum amount equal to the face value of the bond at the time of maturity.
As a result, just like with an FD, if an investor choses to hold a bond to maturity they know exactly the amount that they will get back in advance (One unknown is the credit risk i.e. that the issuer will default but that also exists in FD, a point we discuss later).
Bond Fact#2: Bonds do not always have to be held to maturity. Investors can sell their bonds at the prevailing market price and make an additional gain/loss over the interest income .Price of the bond moves negatively with interest rates.
The big difference between FDs and bonds is that bonds are tradable but FDs are not. As a result, bonds have a price not necessarily equal to the lumpsum amount you will get back (facevalue). Also unlike an FD where if you exit early, you will always have to pay a penalty, you can exit the bond position early and still make a profit if the price of bonds has gone up in the meantime. So how is the price of bonds determined?
To go back our FD example, suppose you made the FD today with 100Rs @ 8% and tomorrow the bank reduced FD rates to 6%. In such a situation your FD has become more valuable. If you could sell an FD, then there will be come buyer who will pay you more than Rs 100 to buy that FD. In fact, people would keep bidding up the price till the yield that they get on their money is 6%. At that point they would become indifferent between buying your FD and opening a new one with the bank. On the other hand if the FD rates instead went up to 10%, then your FD has become less valuable. If you wanted to sell the FD, then you would get less than Rs. 100 for it. In fact the maximum price you would get from the buyer is one which ensures that his yield is 10%. Only at that price would he be indifferent between buying the FD from you and opening another one at the bank.
Bond Fact#3: The prices of bonds with higher maturity move more in response to changes in interest rates. As a result, higher maturity bonds are considered more risky. They also offer potential for more gains (losses) in case interest rates go down (up).
Revisiting our FD example again. Consider two situations. One in which you have just invested your money in a 1yr FD at 8% and rates tomorrow become 10%. Second where you have just invested your money in a 5yr FD at 8% and rates tomorrow become 10%. The second situation is worse because you are locked-in in the lower rate for a longer period of time. The same thing is true of bonds. While all bond prices go down when interest rates go up, prices of bonds with more time to maturity go down by more. The same is true when interest rates go down. Price of bonds with a longer time to maturity go up by more because the higher interest rates have been locked-in for a longer period of term.
The technical concept relevant here is duration. Duration of a bond is the percentage change you would expect in the price of the bond for 1% change in interest rates. Duration is very closely related to the time to maturity – higher time to maturity is almost all of the time associated with higher duration. For those interested in technical details, duration is the weighted average time to maturity i.e. it is an average of the different time horizons when we expect payment from the bond weighted by the payment expected at that time.