Are Fixed Income returns
really ‘Fixed’?
Why are the returns of Fixed income funds not fixed? To understand this, let’s take an imaginary example and try to understand the most important concept of Fixed Income.
In a Fixed Deposit, an investor gives money to a Bank for a fixed period and gets an assurance from the bank on the interest rates he/she will receive at the end of the period.
In Fixed Income funds, the Fund manager invests in a portfolio of Bonds. A bond is a fixed income instrument that represents ‘a loan’ made by an investor to a borrower (typically corporate or government). The borrower promises to pay the lender: principal and interest).
Unlike a Fixed Deposit, the portfolio of Fixed income funds is valued on a daily basis. The valuation of the portfolio changes based on the changes in interest rates in the market.
To understand this let’s analyse some possible situations. Situation #1
Let’s say you make a Rs 1 lakh Fixed Deposit with ABCD Bank for 1 year at 6%. Just after making the fixed deposit, the interest rates of the FD fall to 5%. Now all of a sudden, there is an emergency and you need money.
Q1: At what price will you sell your Fixed Deposit (that you bought at 6%) to someone else?
• Less than 1 lakh • 1 Lakh
• More than 1 lakh Ans 1: More than 1 Lakh
Anyone who makes a new 1-year Fixed Deposit with ABC Bank will get only 5%. Your Fixed Deposit was ‘locked’ at 6% for 1 year. So when an investor buys your fixed deposit he will earn 1% extra. This means, your fixed deposit is in demand and you can charge a premium when you sell it to someone.
If you decide to sell your fixed deposit at ~Rs 1.01 lakh... Now the investor can either:
• Make a new FD of Rs 1 lakh for 1 year with ABCD bank at 5% or
• Buy your FD by paying a slightly higher amount to you (Rs 1.01 lakh) and get 6%
They both are the same. A new investor making a new fixed deposit will make 5% in both cases.
Now replace Fixed Deposit with a Bond.
The reason why Bond prices changes because the bonds have to be valued in the market on a continuous basis. Interest rates always keep changing. That’s why Bond prices always keep changing.
Remember: When interest rates go down, the bond prices go up. (This is why, when interest rates came down from 6% to 5%, the value of the Bond moves up.)
Situation #2
Now let’s reverse the previous situation.
Let’s say you make a Rs 1 lakh Fixed Deposit with ABCD Bank for 1 year at 6%. Just after making the fixed deposit, the interest rates of the FD rise to 7%. Now all of a sudden, there is an emergency and you need money.
Q2: At what price will you be able to sell your Fixed Deposit to someone else?
• Less than 1 lakh • 1 Lakh
• More than 1 lakh Ans 2: Less than 1 lakh
Anyone who now makes a new 1-year Fixed Deposit with ABCD Bank will get 7%. Your Fixed Deposit gives 6% for 1 year. Since an investor will earn 1% less on your FD, it will not be in demand and you will have to sell it at a discount.
You can sell your fixed deposit at ~Rs 0.99 lakh. Now the investor can either
• Make a new Rs 1 lakh fixed deposit for 1 year with ABCD bank at 7% or • Buy your fixed deposit at ~Rs 0.99 Lakh and get 6%.
They both are the same. A new investor making a fixed deposit will make 7% in both cases.
Again, replace Fixed Deposit with a Bond. (A Bond is an agreement between a Lender and a Borrower. Borrower agrees to pay the lender, principal, and interest)
Remember: Interest rates rise the bond prices go down. (This is why, when interest rates moved up from 6% to 7%, the value of Bond moves down.) So the next time you look at a Fixed Income portfolio, think of a See Saw. When interest rates go up, bond prices go down and when interest rates go down, bond prices go up.
In the above example, the tenure of Fixed Deposit was 1 year. So the fluctuation was less. If instead of 1 year, if the tenure of Fixed Deposit is 5 years, the fluctuation will be?
If you made a Fixed Deposit at 6% for 1 year and interest rates fall, the portfolio value moves up. But if the Fixed Deposit is for 5 years and interest rates drop, the benefit is much higher. This is because your Fixed deposit will get ‘extra’ for 5 years, over someone who makes his fixed deposit for 5 years.
Similarly, if you made a Fixed Deposit at 6% for 1 year and interest rates rise, the portfolio value falls. But if the Fixed Deposit is for 5 years and interest rates rise, the fall is much higher. This is because your Fixed deposit will earn ‘less’ interest rate for 5 years, over someone who makes his fixed deposit for 5 years.
IF INTEREST RATES RISE IF INTEREST RATES FALL
YIELDS RISE YIELDS FALL PRICES FALL PRICES RISE
How to analyse interest rate risk?
Interest rate risk is measured by a term called Duration, which is mentioned in an AMC’s fact sheet for each fixed income fund. Eg: If the Duration of a portfolio is 3, it means that if interest rates fall by 1%, the fixed income portfolio’s NAV will move up by ~3% and similarly if interest rates rise by 1%, the NAV will fall by ~3%.
If you are a conservative investor who is looking for very low fluctuation in the portfolio (lower interest rate risk) then you should look at funds like • Liquid Funds (Duration up to 3 years)
• Ultra Short Term Funds (Duration Range 3 to 6 months) • Low Duration Funds (Duration Range 6 to 12 months) • Money Market Funds (Up to 1 year)
Moderate risk taking investor comfortable with moderate fluctuation, can invest in
• Short term Funds (Duration 1 to 3 years)
High risk-taking investors who are comfortable with high fluctuations, can invest in
This note is for information purposes only. In this material DSP Investment Managers Pvt Ltd (the AMC) has used information that is publicly available and is believed to be from reliable sources. While utmost care has been exercised, the author or the AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers, before acting on any information herein should make their own investigation & seek appropriate professional advice. Any sector(s)/ stock(s)/ issuer(s) mentioned do not constitute any recommendation and the AMC may or may not have any future position in these. All opinions/ figures/ charts/ graphs are as on date of
Summary
• Returns in Fixed Income investing are not Fixed. This is because bonds get valued on a continuous basis based on changes in interest rates.
• Bond prices and interest rates move in the opposite direction. • As the tenure of bonds increases, the fluctuation in bond
prices increases.
• Bonds can have a tenure of 1 day to 30 years+.
- Shorter the tenure, lower is the fluctuation in Bond prices (and lower interest rate risk)
- Higher the tenure, higher is the fluctuation in Bond prices (and higher interest rate risk)
• Interest rate risk is measured by a term called Duration.
• So next time you invest in a Fixed Income fund, do check out the Duration before investing.
