Bond markets have always been the favorite asset class in global markets as substantiated by the fact that bond (debt) markets comprise two-thirds of total securities traded. In fact, the size of the global bond market is almost twice that of equity or stock markets. It is hard to imagine that the biggest debt market fund house (Pacific Investment Management Company known as PIMCO) has an asset under management of about $1.9 trillion which was almost the size of India’s GDP in 2014-15.
What is bond trading & how it helps stock traders?
Though the debt market has flourished in India over the years, the larger market is dominated by institutional investors with very limited access to retail investors. However, with the initiation of bond trading on Indian exchanges, retail investors have now an open platform to invest/trade in government bonds. While online trading bonds seems to be fascinating, it can turn out to be trickiest of all. With the increasing opportunities to participate in secondary bond markets to generate decent returns, it is important to have know-how of underlying of bond market.
Understanding bond prices
Let’s assume a bond with a face value of Rs 100, an annual coupon of 10% and a maturity of 10 years. This bondholder will receive a coupon of Rs 10 every year for Bond markets 10 years with a principal repayment at the maturity of the bond. However, these bonds are traded in the secondary markets where they can trade above or below face value (Rs 100 in this case), depending on interest rate or other factors. If the market interest rate rises above the bond coupon rate after the issue of the bond, it will trade below face value (below Rs 100) and vice versa.
Simply put, in a rising interest rate environment, investors get higher interest rates from the newly issued bonds as compared to the previously issued bonds, so old bonds tend to sell at a discount whereas in a falling interest rates scenario, newly issued bonds will be paying lower interest rate as compared to older bonds, and therefore older bonds tend to sell at premiums (over face value) in the market. Hence, on a short-term basis, a bond portfolio can be benefited if interest rates drop and any rise in rates may hurt the portfolio value. For a bond trader, it becomes extremely important to understand the nuances of interest rate implications on bond prices as online trading bonds in secondary markets can become as risky as equities or stock market.
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Measuring movement in bonds: Duration
As we understand now that there exists an inverse relationship between bond price and yield, the key to online trading bond is knowing how much a bond’s price will move on any changes in interest rates.
In order to estimate sensitivity of a bond with respect to interest rate movements, the bond market uses the concept of duration. Duration is always expressed in number of years, which indicates the time in which an investor gets the capital/principal back. In other words, duration is a weighted average of the present value of all cash flows of a bond, which include coupon payments and the principal repayment (face value) to the bondholder at the time of maturity of the bond. Typically, duration is generally less than the maturity of the bond.
Now how does an investor assess the risks with the help of duration. Duration indicates the approximate change in bond prices with every 1 percent move in interest rates. For instance, with one percent fall in interest rate, bond prices will move up by approximately 2 percent for a two-year duration bond. As a technique, duration of a bond portfolio should be reduced by shifting to short-term bonds which are less sensitive to rising interest rates and hence would minimize portfolio losses while duration of a bond portfolio should be increased at times of falling rates to get maximum benefit from rise in bond prices in a portfolio.
Yield of a bond is your return, not coupon: In secondary market, an investor should make an investment decision on the basis of yield which is the actual return rather than the coupon of the bond. Yield of a bond is calculated by the coupon of a bond as a percentage of prevailing bond prices. For instance, a 10% coupon bond may give 9% return only, if the bond price has gone up since the time it was issued, whereas a 9% coupon bond may end up giving 10% return if the bond price has fallen since the time the bond was issued.
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Interest rate cycle of the economy: Though one of the trickiest jobs on the street, a retail investor should try to analyze the trends in the rate of interest to be successful in bond market. An investor can generate excellent returns from investing in bonds if he/she identifies an interest rate cycle correctly. Since bond prices tend to rise in a falling interest rate environment, it would be beneficial for an investor to buy bonds at the start of such an interest rate cycle. So the ideal time to buy bonds from the secondary market is when you have a view that the rate of interest has peaked. For an investor holding bond till maturity, the change in rate of interest does not matter.
As a retail investor, it is important to understand these concepts well before entering in online trading of bond market. On the face of it, bond markets are low risk profile investments; however, failing to understand the risk elements can cause significant loss to a small investor in secondary market.