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Tuesday, August 9, 2016

Investing in corporate bonds - A good debt investment option available for Indian investors

Debt Secondary market remains an unexplored category for Indian investors, though it is very popular globally. This post attempts to highlight few basics about bond investments

Fixed income like #Bonds, #NCDs remains least talked about subject, amongst the indian individual investors. Investors can invest in the primary market and stay put till maturity, as well as trade like equity/ shares. Infact, news reports indicates, bonds have yielded higher return compare to #Nifty or sensex in last one year.  There are two types of bonds traded in the debt market, Government securities (G-sec) and corporate bonds (Tax free bonds, NCD etc). G-Sec are considered to be the safest option with maturity ranging from 91 days (ultra short term) to 30 years (long term).

Corporate bonds are issued by banks, NBFC and corporates involve higher risks compared to G-secs, however they offer higher return comparatively.

When we talk about debt instruments (bonds, NCDs, CDs etc.) we come across terms like coupon rate, annual yield, yield to maturity etc. Let’s understand what is yield and how it is related to coupon rate and bond prices. Yield is annual return on the investment indicating in percentage term.

Analysing Bond investments in two scenarios – 1. Primary market 2. Secondary market. 

Primary market clearly defines that investors enter when the issue opens by the corporate.
For Example – In Primary market, a bond issued with face value - 100, Coupon rate 10%, minimum investment of 10 bonds, chosing annual payout option, Tenor 10 Years . Here the market value of the bonds will remain at Rs. 100 till the maturity. The yield to maturity (YTM) will be 10% = coupon rate since market value is the same as face value. Final payout will be bond price + interest accrued.

Secondary market -  Apart from the new bond issues, there are existing bonds in the market with higher yield, which investors can look at, but one need to understand that the two markets work differently and yield may vary significantly.The secondary market signifies trading in the already listed bonds.

Yield to maturity for secondary market investors – Case 1 – Bond traded at discount
Once the bond is listed on the exchanges, the bond prices fluctuate depending on the asking prices and volumes on the said trading day. The asking price of a bond move based on demand, supply and interest rate cycle. However, future payouts are pre-determined. Suppose, a bond is issued at a face value of Rs.100/-, with a coupon rate of 10% yearly, somebody invests Rs. 10,000 in the issue, the yearly interest payout remains at Rs. 1000 for the rest of the tenure. Incase, the bond prices fall to Rs. 90, still the coupon payout will be Rs. 10. So, now the same bond will be available at 9000 Rs. And, will still be able to fetch annual return of Rs. 1000, as the coupon payments on the bonds remain the same, so the annual return (or annual yield) is 11.1%.
In this scenario, the current bond price<issue price. Hence, it can be called as “discount”. One, who is investing in this situation, will get higher coupon pay out, i.e. higher yield. It may happen in the higher interest rate cycle, (the interest rate moves upward).   

Yield to maturity for secondary market investors – Case 2 – Bond traded at premium
In exactly opposite scenario, if the interest rates fall post the bond issue, the interest of the buyers increases the exiting bonds available in the secondary market, as they offer higher coupon rate, however, the buyer may need to pay premium as the askprice of the existing bonds with higher coupon rate move upwards due to increased demand. Now, if the bond price increases to Rs. 110, for 10,000 investment, coupon payout remains at 1000, and on the current NAV, the value of the investment will be 100*110 = 11000. This is a win-win situation for the primary market investor. However, in the secondary market, the coupon pay-out remains at Rs. 1000, against the bond price of Rs. 110. Hence the new investor is getting 9.09% interest pay-out, lesser than the coupon offered in the issue. If current bond price> issue price, it is said the bonds are sold at premium
Incase, there is no change in the ask price than the issue price, it is known as at par value(face value).

In the secondary market, yield-to-maturity includes coupon payment and the additional gain (bought at discount) or loss (if bought at a premium).

The points to be noted –

1. During the rising interest rate environment, investors can take advantage of the discount on the bond price, and enjoy the high yield as the coupon payout (interest payment) remains the same on lower cost of investment.

2. During the falling interest rate regime, the early investors can look at entering existing bonds with high yield option to capture a good yield, it may attract premium.

3. The liquidity in the instrument in the secondary market plays an important role. Size of the issue, investor interest, maturity date etc plays important role in the volumes. If the volumes are not adequate, one may need to wait or pay a premium.   

4. In secondary market, the bonds carry risks on interest rate,liquidity, credit and market risks

For trading in bond market you need to have a demat account. Please contact your share broker.  
You may check Investing answers YTM calculator to find approximate yield to maturity when you buy on secondary market.

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