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.