Bond prices have an inverse relationship with market interest rates and it is this relationship that will generate capital gains or losses IN THIS article, we wish to highlight that bonds are a lucrative investment instrument, especially in a declining interest rate environment.
In this regard, the recent cuts in the overnight policy rate (OPR) by Bank Negara Malaysia (BNM), has direct bearing on the workings of the capital market and value of financial assets traded in that market, including bonds. Since the beginning of this year, BNM has cut its benchmark interest rate by 150 basis points (bps) bringing the OPR to 2 per cent.
The cuts in BNM's benchmark interest rate has resulted in interest rate adjustments taking place in the economy. These interest rate adjustments mean that the total amount of money demanded is being equalised to the money supply available in the economy. During this process of interest rate adjustments, financial assets will either gain or lose value as investors switch out of cash holdings to buy interest earning assets.
We will illustrate this adjustment effect on bond prices specifically with a simple example.
Interest Rate Movementsand Capital Gains/Losses
To begin with, bond prices have an inverse relationship with market interest rates and it is this relationship that will generate capital gains or losses. In order to understand this inverse relationship, the reader has to bear in mind that every bond carries a fixed payment, also known as coupon rate for the entire life of the bond.
This stated coupon rate is calculated using the prevailing market interest rate at the time when the bond was issued. The coupon is a fixed payment which cannot be changed over the life of the bond, even if market interest rates change (In fact, this is the reason why bonds are sometimes referred to as fixed income securities).
What then can change when market interest rates change? It is the price component, also known as the initial face value or bond maturity price, that will change and this is what we are going to demonstrate with the example below.
Assuming that the interest rate is 10 per cent at the time of issuance, a particular bond pays RM5 a year in interest in perpetuity and the current market price of the bond is RM50. Simple maths will show you that the fixed payment of RM5 is 10 per cent of the face value of bond (RM5 divide by RM50). Note that the RM5 payment is the stated coupon rate (usually made annually).
Now, suppose market interest rate rises to 20 per cent and remember the coupon on the bond is still RM5, calculate the price of bond? Doing the maths will show you that the bond has to be sold at a discounted value of RM25 (10per cent/20 per cent x RM50). At this new price, the stated coupon of RM5, is now equivalent to the new market interest rate of 20 per cent (RM5 divide by RM25). Note the new bond price of RM25 is lower than the initial bond price RM50.
We can see when interest rates rise to 20 per cent, the coupon rate did not change for it is fixed in perpetuity but bond prices did. So what does this mean for the bond holder as well as the investor? For the holder of the bond, the only way he can sell the bond would be to sweeten the deal so that the buyer or investor gets the market interest rate for the bond. That meant discounting the price of the bond to make it attractive for the investor to purchase.
For the investor, the only way he would be willing to buy that bond is, if it cost no more than other investments that yield the same stream of returns in the future.
Next, market interest rates decline to 5 per cent, and remember the bond is continuing to pay a coupon rate of RM5 or 10 per cent of the initial face value. What do you think happens now to the bond price? Doing the maths again will show you that your bond can now be sold for a premium of RM100 (10 per cent/5 per cent x RM50) and the coupon of RM5 now is equal to the market interest rate of 5 per cent (RM5 divide by RM100). Note the new bond price of RM100 is higher than the initial bond price of RM50.
From the above example what needs to be understood here is that when interest rates rise, bond prices decline and bond holders suffer a capital loss on the price of the bonds. Conversely when interest rates decline, bond prices will rise and the bond holders make capital gains on the price of bonds. How? Because investors purchasing the bond are willing to pay a premium on bond prices.
Why pay a premium? If the fixed payment or stated coupon of the bond is higher than current market interest rate, it is clearly a signal to buy and any investor would be willing to pay a premium for the bond (that is pay more than the bond's maturity price).
This point is very relevant for the current situation when global market interest rates are declining and in some cases converging towards zero interest rate.
On the other hand, if the bond's fixed payment or stated coupon is lower than the interest payments expected by the market, the bond will sell for less than the bond's maturity amount. The difference (premium or discount) is computed by discounting all of the future cash amounts.
(Note: The above calculation is a simple illustration to highlight the inverse relationship between interest rates, bond prices and the resulting effect of capital gains or losses. It does not represent an actual computation of bond prices as that is a more complicated process. There are other variables to be considered too and we will discuss some of these variables in succeeding paragraphs.)
Yield Changes and Credit Quality
The next aspect that affects bond returns is yield changes. Simply put, the bond yield is the measure of income generated by a bond calculated as the interest paid divided by the price of bond. So, if your bond is selling at RM1,000 or par, the coupon payment, which is RM100, then becomes equal to the yield, which in this case is 10 per cent.
But note that bond prices are affected by, among other things, the interest offered by other income producing bonds. As such, bond prices fluctuate, and so do bond yields.
Each bond carries a different yield depending on the widely varying risk profiles of borrowers. For example, if the borrower is a government, it would be deemed risk-free as government has the ability to generate revenues through taxation to repay the bonds.
Thus, owing to this risk-free status, government bonds pay the lowest yield.
Corporations, on the other hand, undertake business ventures and the ability to repay carries varying degrees of uncertainties. Corporations with good financial standing have better ability to meet all their financial obligations, including the timely repayment of all interests and principal amount of borrowings.
These are high-quality issuers with high credit ratings, known as "investment grade". Conversely, corporations with weak business prospects are riskier and the probability of failure is higher. Issuance from these entities are known as "non-investment grade" bonds and it carries higher yields compared to investment grade bonds as investors need to be compensated for taking additional risk.
The Role of Rating Agencies in Gauging Credit Quality
Assessment of credit quality of bonds is largely undertaken by bond rating agencies. In Malaysia, there are two independent rating agencies, namely Rating Agency Malaysia Bhd (RAM) and Malaysian Rating Corp Bhd (MARC). Corporate bond ratings start from AAA (highest quality) to D (lowest quality or defaulted). Bonds ascribed ratings of BBB and above are "investment grade" bonds while those below BBB are "non-investment" grade bonds.
Duration
Finally, we may also use duration analysis to estimate how the change in general level of interest rates affects prices of bonds.
In a very simple sense, the concept of duration measures how quickly a bond will repay its true cost. It is a measurement of how long (in years) it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.
Some factors that affect a bond duration are as follows:
* Time to maturity
Consider two bonds that each cost RM1000 and yield 5 per cent. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.
* Coupon rate
A bond's repayment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.
Conclusion
That being said, the way an investor chooses to invest in bonds for the short-term or the long-term depends on the investor's investment goals, time frames and the amount of risk the investor is willing to take.
More importantly when considering a bond investment strategy, remember the importance of diversification.
Investors opting for bonds as an investment should also think of diversifying risks even within the bond investments by creating a portfolio of several bonds, each with different characteristics.
There are various types of bonds available in the market with specific characteristics, which can be confusing for the uninitiated or the average investor.
This is where the average investor would need to seek professional advice since managing bond funds requires lots of resources, from analysing interest rate directions and credit quality to actively trading and hedging the portfolio.
Such arduous tasks are best handled by professional fund managers; especially those established ones with proven track record in economics, credit analysis and portfolio management as well as proper risk management.
This article was contributed by the Funds Management Division of AmInvestment Bank Group.
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