The past few weeks have been extremely turbulent and volatile for the Indian financial markets—stock markets have been moving up and down in crazy moves; bond yields have been galloping upwards resulting in falling bond prices; plus there have been reports of serious frauds affecting Indian banks, especially public sector banks (PSBs). The most striking of all these events is the realisation for many investors in mutual fund (MF) schemes that they have lost money in income/debt/bond MF schemes.
Yes, it’s very difficult for a fixed-income investor to digest the fact of losing his capital or earning negative returns in fixed-income products. History repeats itself, if we don’t learn from it. Market cycles repeat. If one does not learn from bear markets, one may have to surrender a majority of the gains made in the bull market.
Back to the title of this piece. You usually don’t make money from debt MF schemes because of multiple reasons. Although debt MF schemes are called fixed-income securities, there are different types of risks while investing in them—credit risks, interest rate risks, yield curve risks, liquidity risks, basis risks, etc.
Interest Rate Risks: A very misunderstood, formidable, unquantifiable and underrated risk is ‘interest rate risk’. This risk is directly related with the maturity of a security—the longer the maturity, the higher the risk (and return). For long-dated fixed-income securities, when interest rates increase, the price of the bond decreases and vice versa. Therefore, if you invest in income MF schemes during an increasing interest rate environment, the value of the scheme is likely to depreciate.
Absurd Advice from Advisers: Investments in debt schemes should ideally be done when the interest rates are high because of two factors—firstly, the inherent yield of the income scheme would be elevated which will ensure high accrual income; secondly, if interest rates are currently high, other things remaining constant, there is more likelihood and scope of their going down in the future.
However, unfortunately income schemes are generally not marketed when interest rates are high; they are actually promoted when interest rates have already moved down. When interest rates have already softened in the recent past, the return from debt schemes would be unsustainably super normal which would appear further bloated when it is incorrectly annualised.
Fund Manager Bias: Any fund manager hates when his scheme underperforms. And the fund manager would certainly not like a negative return on a debt product like an income scheme. Hence, during an increasing interest rate environment, the fund manager would unjustifiably reduce the maturity of the scheme and start managing an income scheme like a short-term plan, going against the very mandate of the scheme.
Poor Performance Does Not Come Cheap: Income schemes are nothing but interest-yielding debt products. But when someone deducts high fees from the interest rate, what would happen is a substantial fall in the income yields. That is what happens with income schemes which are loaded with high fund management expenses. After all, poor performance does not come cheap!
There are some distinct advantages of investing in debt schemes like tax-arbitrage schemes, since return on growth schemes is treated as capital gains compared to interest income on bank fixed deposits (FDs) and, hence, subject to lower tax rates along with indexation benefits, a chance to ride the interest rate cycle, etc.
However, your success with income schemes, like any other investment, would depend on two factors. Firstly, the entry point of your investment—timing is very important while investing in income schemes, if you invest just before an increasing interest rate cycle, unfortunately, it would take many months, or even couple of years, to regain the capital which you might have lost, by way of interest accrual.
Secondly, the exit point. An income scheme, like any other product, is not an investment for the long term. Once you ride the downward shift in the yield curve, it is time to pack your bags, book your profits and get out of it. Learn to ride the interest rate curve earning above-normal profits from your income scheme investments and not allow the fund manager or adviser to have a ride with your money.
Bond Mathematics—Simplicity in Complexity
To make readers understand interest rate risk associated with fixed-income securities, which is difficult for the mathematically challenged, I make an attempt to explain in a simple manner. Interest rate risk is one of the deadliest, yet misunderstood risks, in debt instruments. For example, a long-term government of India security (G-Sec) may have zero credit risk (because the government can literally print notes and pay back the loan), but it has one of the highest interest rate risks. Interest rate risk is directly related with the maturity of a security. Let us understand the two important contributors of interest rate risks—duration and convexity.
Duration: I have seen many investors confuse duration with maturity. However, they are distinctly different. Maturity is simply when the fixed-income security will complete its tenure and pay back the principal. For example, the maturity of a 10-year paper will be 10 years at the time of issue. On the other hand, duration is the time within which the investor receives back all the cash flows related to the security, i.e., interest and principal.
For example, if there is a 10-year maturity paper paying yearly coupon at the interest rate of 8.0%pa (per annum) issued at par (Rs100) it will have the following cash flows, 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 108 which will be paid at the end of every year for the next 10 years until it matures. The Rs8 is the interest at 8.0%pa on Rs100 par value. Kindly note that, at the end of the 10th year, the investor will receive Rs108, i.e., Rs100 of principal + Rs8 of the 10th year’s interest. This example clearly shows that, although the maturity of the security is 10 years, the investor receives cash flows at regular intervals much before the final maturity of the security.
That brings me to the concept of duration. The duration of a bond is defined as the “weighted average term to maturity of a security’s cash flows.” Since the cash flows on a security are received piecemeal before the actual maturity of the security, the duration of all coupon-paying bonds will be less than its maturity. And as a zero coupon bond does not pay any interest during its life, its duration = maturity.
Duration is useful primarily as a measure of the sensitivity of a bond’s market price to interest rate (i.e., yield) movements. It is approximately equal to the percentage change in price for a given change in yield. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1%pa increase in market interest rate. So, a 10-year bond, with a duration of seven years, would fall approximately 7% in value if the interest rate increased by 1%pa. In other words, duration is the elasticity of the bond’s price with respect to interest rates. The summary of duration characteristics is as follows:
The duration of a zero coupon bond will equal its term to maturity.
The duration of a coupon paying bond will always be less than its term to maturity.
There is an inverse relationship between coupon and duration. The higher the coupon of a bond, the lesser its duration and vice versa. The logic is simple: because the higher the coupon, the sooner will the cash flows accrue to the investor; hence, the lesser the interest rate risk associated with future cash flows.
There is generally a positive relationship between duration and term to maturity. Note that the duration of a coupon bond increases at a decreasing rate with maturity and the shape of the duration/maturity curve will depend on the coupon and the yield-to-maturity (YTM) of the bond.
There is an inverse relationship between YTM and duration.
Sinking fund and call provisions can cause dramatic change in the duration of a bond.
Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As interest rates change, the price does not change linearly, but rather is a convex function of interest rates. Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes
. Convexity deals with the curvature of the price/yield relationship or chart.
Specifically, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the convexity as the second derivative. Convexity also gives an idea of the spread of future cash flows. Just as the duration gives the discounted mean term, so convexity can be used to calculate the discounted standard deviation, say, of return.
Note that duration can be either negative or positive, depending on the way the interest rates move, but convexity is always a positive feature of the bond. The exception to this rule is in the case of ‘callable bonds’ where the convexity is a negative feature. By positive feature of convexity, I mean that, for a given change in interest rates and the modified duration of a bond, the change in the price of the bond will be in favour of the investor. For example, because of the positive feature of convexity, when interest rates rise, the price of the bond will fall less than that indicated by duration and when interest rates fall, the price of the bond will rise more than that indicated by duration.
This is because when we study the price/yield relationship of a coupon-paying option-free bond, the larger the increase in the YTM, the greater the magnitude of the error by which the modified duration will over-estimate the bond’s price decline; the larger the decrease in the YTM, the greater the magnitude of the error by which the modified duration will under estimate the bond’s price rise. As the YTM changes, the bond’s duration changes as well. Thus, modified duration is an accurate predictor of price change only for vanishing small changes in YTM.
Without making it complicated, the change in price of a fixed-income security is duration times the change in yield, i.e., for a security having a modified duration of seven years, for every 1% (100bps) decrease in yield (interest rates), the price will go up by 1 * 7 = 7% and vice versa. Due to convexity of the bond, the gain will be little more than 7% in case of interest rate decline and the loss will be little less than 7% in case of interest rate rise.