Hsbc Presentation

Presentation on Debt Market IDFC Mutual Fund

Debt and Interest Rate • Investment Horizon ( IH) = Time during which investor would invest; • Remaining Maturity (RM) = Time remaining till the issuer of the instrument pays to the holder . • If IH< RM , the investor has price risk and debt behaves in the same manner as equity. • IH= RM and if the issuer is government , the investor does not assume any price risk. • IH>RM then reinvestment risk is present.

IH < RM • Investor would gain if interest rate goes down for all debt instrument except one ; • The following rules are followed in such situation : – Price and Yield To Maturity are inversely related : • YTM is synonymous with interest rate for the remaining maturity of the debt instrument;

– Change in price is directly proportional to : • Both duration and modified duration ; • Convexity ;

IH < RM • Both duration and Modified duration is : – Directly proportional to tenure or remaining maturity of the instrument ; – Inversely proportional to coupon and YTM of the instrument;

• This strategy is followed for bond management .

IH< RM Interest Rate is expected to go down Price would go up

Long Duration bond would be desirable

Higher Tenure

Lower Coupon Lower YTM

Interest rate to go up Price would go down

Short duration bond would be desirable

Lower Tenure

Higher Coupon Higher YTM

Key to prediction on interest rate • The key to investment in debt fund is the prediction on interest rate ; • Several factors affect interest rate ; – – – – –

Inflation Growth Monetary policy Fiscal policy Government borrowing programme

Broad Parameters for predicting interest rate Growth Rate

Inflation

Fiscal Deficit

Likely interest rate

Low

High

High

Low

Low

Low

High

Low

High

Low

High

Status quo

High

High

Low

High

Total Money Supply Money with Central Bank Private Govt

Total Money Supply in Higher Fiscal Deficit Money with Central Bank Private Govt

Interest rate goes up

Total Money Supply in Higher Fiscal Deficit Money with Central Bank Govt

Govt

Private

Private Placement With RBI and interest rate goes Down or remains same

10 Year G Sec Yield Trends ( %)

8.64 7.45

7.08

6.23

6.36

5.26

July-08

Septemb October- Decembe Febr March-09 er-08 08 r-08 uary-09

Explanation …. • Growth is down ; • Inflation is down; • Yield should go down ; • But yield is going up; • How to explain this ?

Explanation …. • More Fiscal deficit announced by Government ; • More Fiscal deficit means more borrowing by Government ; • More borrowing means less amount available to corporate • This is pushing yield;

Movement of Yield for last 6 months 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 July-08 Septemb October- Decembe Febr March-09 er-08 08 r-08 uary-09

10 Yr 5 Yr 1 Yr

Open Market Operation ( OMO) • RBI controls money supply by selling or buying securities. • RBI buying securities : RBI lending money ; Repo Rate -1 day • RBI selling securities : RBI borrowing money ; Reverse Repo Rate -1 day

Repo Transaction

Securities

Money 100

RBI

Bank

RBI

Bank

100+Repo Rate Securities 105

CBLO Transaction

Securities

Money 100 Bank/ Non Bank

Bank/ Non Bank

Bank/ Non Bank

Bank/ Non Bank

100+CBLO Rate Securities 105

Call Money Transaction

Call Receipt

Money 100

Bank

Bank

Bank/ Non Bank

Bank/ Non Bank

100+ Call Rate Call Receipt

Impact of Repo Rate MIBOR &CBLO 10 Yr G Sec

5 Yr G Sec Repo Rate

1 Yr G Sec

Correlation ( Apr 2000- Dec 2006) RREP

1.00

Call

0.86

1.00

TB91

0.86

0.95

1.00

TB364

0.84

0.92

0.99

1.00

Yield10

0.78

0.88

0.96

0.98

1.00

Way forward : My Personal View Point • More Yield means more borrowing cost by Government ; • More Yield means more MTM Loss by banks on their investments ; • Lower profit by banks ; • Already hit by lower interest income due to slowing down of economy; • Banks are citing G Sec yield as alibi of not cutting down further PLR : – BOI Chairman and ICICI Bank MD & CEO ‘s views;

Way forward : My Personal View Point • The ultimate aim is to reduce cost of borrowing. • RBI would purchase bond in the open market . • Private Placement of bond to RBI is possible . • FII in G Sec market can come. • The 10 Yr bench mark yield should come down .

Way forward • Short term , very volatile. • Short term investment should be in money market investment . • From 1 month to 2 month : – Portion in short term – Portion in 5 Yr YTM – Portion in 1 Yr YTM

• From 2 months to 9 months : – Portion in 1 Yr YTM – Portion in 5 Yr YTM – More in 10 Yr YTM

Corporate Bond • Two factors in Corporate Bond YTM : – Risk Free YTM – Risk Premium • Function of Credit Risk – Would go up during recession due to downgrading

• The difference between these two YTM is called Yield Spread.

10 Yr G Sec , AAA Yield and Spread 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 July-08 Septe Octobe Decem Februa Ma mber- r-08 ber-08 ry-09 rch-09 08

10 Yr 10 Yr AAA Rate Bond Spread

Asset Backed Securities ( ABS) Asset Backed Securities in a general sense

CDO Mortgage Backed Securities ( MBS) Residential Mortgage Commercial Mortgage

ABS in a Narrower Sense •Credit Card •Equipment •Student Loan •Music Royalties

CLO Loan owned By Bank

CBO Bonds Traded in the Market

Process of securitisation Credit Enhancer Provides Credit Enhancement

Trustee

Originator / Servicer Receives Fund

Transfer Of Assets

Loan sale

S.P.V.

Principal And Interest Minus Revenues Servicing Debt Fees

Disburses Revenues to Investors

Receives inflow From reference Issuer of Debt Securities

Underwriter

from

Securities

Investors

Distribution Of Debt Securities

Is investment in securitised asset risky ? • The investor may not know the quality of the underlying assets. • The investor is depending on the credit rating assigned by the rating agency. • If the underlying asset quality is bad but rating is higher , investor incurs the risk . • Under such situation, securitisation is definitely riskier. • Securitised instrument of Real Estate and Finance companies are riskier as the underlying asset is riskier by nature.

IO and PO Securities

Amount

1500.00 1000.00 500.00 0.00

PO IO

Months Time in Month

PO IO

PO Securities – Principal Rs 100000/• Total payments to a PO are fixed— – all that is uncertain is the timing of those payments. – Prepayments are desirable because the holder of the PO receives the money earlier. – With interest rate decrease , the prepayment probability goes up . – So the investor would get the money faster . – The price would go up .

PO Securities – Principal Rs 100000/• A invests in PO for 120 months. Under normal interest rate ( 10%p.a.) , the investor would get back the money ( Rs 1,00,000/-) after 120 months. • If the interest rate goes down , the loan borrower would pay the money earlier as the same EMI would close the loan earlier. • So the investor would recover the same money ( Rs 1,00,000/- ) earlier. • The price in the market should go up. • PO and interest rate is inversely proportional.

IO Securities – Interest amount of Rs 58581 @ 10% p.a. for 120 months • A invests in IO for 120 months. Under normal interest rate ( 10%p.a.) , the investor would get back the money ( Rs 58581/-) after 120 months. • If the interest rate goes down , the loan borrower would pay the money earlier as the same EMI would close the loan earlier. • So the investor would recover lower amount of money because interest amount would be lower . For example, if interest rate goes down to 9% , the investor would not get Rs 58581/- but it would get Rs 48,255/- . But PO holder would get the amount of Rs 1,00,000/- but in 113 months. • The price of IO would go down with interest rate .

Interest Rate and Price

Instrument

Yield going up would result in Price Decrease

Yield going down would result in Price

Coupon Bearing Instrument

Decrease

Increase

Principal Only Securities

Decrease

Increase

Interest Only Securities

Increase

Decrease

Discounted Instrument

Increase

Interest Rate and Desirable Instrument Yield going up Should result in buying IO

Yield going down would result in buying Fixed Income, Discounted Instrument , PO

All recommended solutions are personal opinion of Prof Praloy Majumder, author of this presentation . Mutual fund investment is subject to market risk and investor must use due diligence before choosing the investment plan recommended here.

Situation I – Bearish Equity Market , High Interest Rate , Low Inflation and Low GDP growth rate • For ultra short term investment ( with an investment horizon of up to 120 days ) : Preferable Liquid Fund and Liquid plus ; • As we are not sure about the timing of interest rate cut; But definitely interest rate would be cut in the immediate future;

• For short term investment ( with an investment horizon of 120 days to 365 days ) : Gilt edged fund of higher average maturity ; • As interest rate is expected to come down , the higher average maturity gilt edged fund would generate more capital appreciation;

Situation I – Bearish Equity Market , High Interest Rate , Low Inflation and Low GDP growth rate • For medium term investment ( with an investment horizon between 1 to 2 years ) : – More in Bond Fund ; – Less in Equity Fund ;

• For long term investment ( with an investment horizon of 2 years and above ) : – More in Equity Fund ; – Less in Bond Fund;

Situation II – Bullish Equity Market , Low Interest Rate , Low Inflation and High GDP growth rate • For ultra short term investment ( with an investment horizon up to 90 days ) : – More in Equity Fund ; – Less in Bond Fund ; – Minimum in Gilt Fund;

• For short term investment ( with an investment horizon of up to 1 year ) : – More in Equity Fund ; – Less in Bond Fund;

Situation II – Bullish Equity Market , Low Interest Rate , Low Inflation and High GDP growth rate • For medium term investment ( with an investment horizon between 1 to 2 years ) : – More in Equity Fund but lesser amount compared to first two types of investment pattern; – Less in Bond Fund but higher amount compared to first two types of investment pattern; – Minimum in Gilt Fund;

• For long term investment ( with an investment horizon of more than 2year ) : – Equal amount in Equity Fund ; – Equal amount in Debt Fund ;

Situation III – Bullish Equity Market , High Interest Rate , Low Inflation and Moderate GDP growth rate • For ultra short term investment ( with an investment horizon up to 90 days ) : – More in Equity Fund ; – Less in Gilt Fund; – Minimum in Bond Fund ;

• For short term investment ( with an investment horizon of up to 1 year ) : – More in Equity Fund ; – Less in Bond Fund ;

Situation III – Bullish Equity Market , High Interest Rate , Low Inflation and Moderate GDP growth rate • For medium term investment ( with an investment horizon between 1 to 2 years ) : – More in Equity Fund; – Less in Gilt Fund;

• For long term investment ( with an investment horizon of more than 2year ) : – Equal amount in Equity Fund ; – Equal amount in Debt Fund ;

Investment Advice- Conservative and Passive Management Total Fund ( Rs lacs)

1-3 Months

3-9 Months

9-18 Months

18-24 Months

( Rs lacs)

( Rs lacs)

( Rs lacs)

( Rs lacs)

More than 24 Months ( Rs lacs)

20

5

5

10

Investment Pattern 20

4

1

+4

Short Term Gilt Fund Debt Fund ( 1yr instruments , T bill, CBLO )

1+10 Equity Fund

Investment Advice – Aggressive & Active Management Total Fund ( Rs lacs)

1-3 Months

3-9 Months

9-18 Months

18-24 Months

( Rs lacs)

( Rs lacs)

( Rs lacs)

( Rs lacs)

More than 24 Months ( Rs lacs)

20

5

5

Investment Pattern 20

4

5

+ 10

Short Term Gilt Fund Debt Fund ( 1yr instruments , T bill, CBLO )

10

Key Take way from sessions • Debt Fund behaves like equity fund in most of the cases . Why ? – Investment horizon is less than maturity of invested instrument .

• Interest rate prediction is important : – Increase in interest rate would reduce the debt instrument’s value except IO ; – Increase in interest rate is associated with : • Higher inflation ; • Higher borrowing by Government ; • Higher MSS by RBI ;

• Point prediction is difficult but range prediction is more realistic attempt.

Key Take way from sessions • If interest rate is going up , invest in short maturity investment with matching maturity and roll over till the interest starts coming down. • In times interest starts coming down , invest in gilt fund. • For long term investment , invest in Equity.