Bond investing in India is mostly restricted to institutions and high net worth individuals as retail investors tend to prefer other investments. This is a bit surprising as the same group of investors prefer traditional investment avenues like fixed deposits and small savings schemes all of which are fixed-income investments.
Though the interest towards bond investing is growing, especially via mutual funds, the exposure to the asset class is far from being optimal. It would be interesting for investors to know the dynamics of this asset class as well as how it impacts equity investing. Let’s begin with an overview of the asset class and how it functions.
Bills and Bonds – What are they and how do they work?
Bills and bonds spearhead fixed income securities. These are essentially IOU instruments. In a stock IPO or investment, an investor becomes part of that company whose stock he invests in. However, when an investor invests in bonds, he gets an assurance from the issuer that the principal will be repaid once the period of the issuance is completed. Depending on their form, bonds also pay period interest to the holder. Alike equities, bonds can be traded in the secondary market. Bonds can be issued either by the government and municipalities or by corporates.
The difference between bills and bonds is based on the tenor of issuance. Issuances for less than a year are typically known as bills. This is the reason why the 91 day, 182 day and 364-day papers issued by the central government are known as Treasury Bills. Issuances of other durations are known as bonds. The tenor of bonds usually ranges from 2 to 30 years but issuances up to 100 years and perpetual bonds are also in existence.
The interest rate that bonds carry with them at the time of issuance is known as coupon. Coupon payments can be quarterly, semi-annual (every six months) or annual. Discount bonds are those which are issued at a discount of their face value and at the end of the term, the face value is paid out with the difference between them functioning as interest. Sometimes, zero coupon bonds are also issued.
Entities known as credit rating agencies rate corporate bonds. The ratings are assigned separately to each bond issuance even if the issuances are by the same issuer. These ratings are an indicator of the repayment ability of the bond. Bonds which are riskier tend to carry higher coupons (and lower ratings) to compensate investors adequately for the risk they are taking.
Understanding bond yield
While coupon is the interest that is paid out, bond yield represents the overall return in the hands of an investor. Yield calculation can include interest payments, time value of money, as well as whether the bond was bought at a premium or discount. Similar to stock prices, bond prices, and yields change on a daily basis based on demand and supply. If a bond is bought at a price higher than its face value, it is considered to have been bought at a premium. A purchase below the face value is considered to be on discount. If a bond has been bought on the secondary market after its issuance in the primary market, then a premium or discount becomes relevant to yield calculation.
In its simplest form, bond yields are calculated as follows:
Other more complicated forms of yield which account for the factors as mentioned earlier are known as Yield to Maturity, Effective Annual Yield, and Bond Equivalent Yield, among others.
The price of a bond and its yield have an inverse relationship. This means that as the price of a bond falls, its yield rises and vice versa. The reason behind this relationship follows from the formula given above. Since the interest paid out by a bond in a year is fixed and is calculated from the coupon rate and face value, in order to maintain the amount of interest payment, bond yields need to move with any change in bond prices; an upward movement in prices warrants a downward movement in yields and vice versa.
Bond yields are affected by the interest rate environment in the country. If inflation is on the rise and warrants a rate increase by the central bank then bond yields tend to rise as well. On the other hand, when there is a rate cut to stimulate the economy, yields tend to decline. This is also where the relationship between stocks and bonds can be highlighted.
The impact of bond yields on stocks
After having gained an insight into bonds and how bond yields function, we can now look at how bond yields impact the stock market.
As a broad thumb rule, bond and stock prices move in opposite directions. While bonds offer a stable income and are perceived to be safer than equities, stocks have the potential to provide stellar returns – an aspect not associated with bonds. But since resources are limited, bonds and stocks need to compete for them.
When a country is witnessing economic expansion, investors move to the stock market due to the allure of excellent returns. Since resources are limited, this happens at the cost of bonds whose prices fall and yields rise. Therefore, a rise in bond yields can signal a positive impact on stocks during an economic boom. On the other hand, when an economy is undergoing rough weather, investors prefer the safety of bonds which results in an increase in bond prices and a decrease in yields. This leads to money moving away from stocks and a decline in stock indices.
A change in interest rates effected by a central bank can also impact stocks. If interest rates are increased, they can lead to a rise in bond yields, as outlined above. This can, in turn, signify a rise in stock indices. On the other hand, a rate cut can have a negative impact on stock prices.
There are times when bond and stock prices can move in unison. When markets are topping out, there is a much higher supply of investable resources compared to investment avenues. This leads to a rise in both stock and bond prices. On the other hand, when markets are tanking, investors tend to panic and sell across the spectrum of financial markets, thus leading to a decline in both stock and bond prices.
Apart from the broad equity market, bond yields can impact individual stock prices as well. For a company with sizable debt, an interest rate cut is a piece of positive news for its stock price as it means it can borrow or refinance its outstanding loans at cheaper rates. A rate hike, meanwhile, is contrary as it means higher rates of borrowing for companies as well as more expensive loan rates, which can drive down consumer demand, and thus, stock prices of companies.
This relationship between bond and stock prices can be important for investors when deciding on re-balancing their investment portfolio.