Investing in fixed income securities

Even an equity-focused PMS client keeps a large part of her wealth in bonds, deposits and debt funds, and several portfolio managers run debt and multi-asset strategies. The exam asks you to price a bond, explain why its price falls when rates rise, and read a credit rating. These are mechanical skills; practise them once and they stay.

Bond vocabulary

A bond is a loan. The issuer promises to pay interest (the coupon) at fixed dates and return the face value (principal) at maturity. The coupon rate is fixed at issue; what changes every day is the price in the market and therefore the yield a new buyer earns. Other terms you need:

• Zero-coupon bond: no interest, issued at a discount, redeemed at face value.
• Floating-rate bond: coupon resets with a benchmark such as the repo rate or T-bill yield.
• Callable (issuer may repay early) and puttable (holder may demand early repayment).
• Secured vs unsecured, and senior vs subordinated, which decide who gets paid first in a default.
• Clean price excludes accrued interest; dirty price (what you actually pay) includes it.

The Indian debt market

The government is the largest borrower. Treasury bills (91, 182 and 364 days) are zero-coupon instruments; dated government securities (G-Secs) run from one to forty years; state development loans (SDLs) are issued by states. RBI conducts the auctions and runs the NDS-OM trading platform; retail investors can buy through RBI Retail Direct. Companies issue non-convertible debentures (NCDs) and bonds, banks issue certificates of deposit, and companies issue commercial paper for short-term needs. PSU bonds, tax-free bonds and perpetual bonds (AT1) complete the menu.

Credit rating agencies (CRISIL, ICRA, CARE, India Ratings) grade the issuer's ability to pay. AAA is the highest; BBB− and above is investment grade; below that is speculative; D means default. Ratings are opinions, not guarantees, and they can be downgraded suddenly. For a discretionary PMS, SEBI limits investment in unrated or below-investment-grade debt to 10% of the client's assets.

Price and yield move in opposite directions

A bond's price is the present value of its future cash flows, discounted at the market yield. If yields rise, the fixed coupons are worth less today and the price falls. If yields fall, the price rises. This single relationship explains most bond behaviour.

The bond trades below face value (at a discount) because its 7% coupon is less than the 8% the market now demands. The current yield of 7.19% understates the true return; YTM of 8% also counts the ₹25.77 gain when ₹1,000 is repaid. If the market yield had been 6%, the same bond would trade above par at about ₹1,026.7.

Duration: how sensitive is the price?

Macaulay duration is the weighted average time to receive the bond's cash flows, in years. Modified duration converts it into price sensitivity: the approximate percentage change in price for a one percentage point change in yield. Longer maturity and lower coupon mean higher duration and more interest rate risk.

For the bond above, Macaulay duration works out to about 2.81 years and modified duration to 2.81 ÷ 1.08 = 2.60. If yields rise 50 basis points, the price falls by roughly 2.60 × 0.5% = 1.30%, from ₹974.23 to about ₹961.6. Convexity is the correction for the fact that this relationship is curved rather than straight; it makes actual price rises slightly larger and falls slightly smaller than duration predicts.

Yields also differ across maturities. The yield curve plots G-Sec yields against maturity; it normally slopes upward because lenders want more for locking money away longer. The extra yield a corporate bond offers over a G-Sec of the same maturity is its credit spread, and spreads widen when the market grows nervous about defaults.

The risks a fixed income investor carries are interest rate risk (measured by duration), credit risk (rating and spread), reinvestment risk (coupons reinvested at lower rates), liquidity risk (thin trading in corporate bonds) and inflation risk (fixed coupons lose purchasing power).

Fixed income inside a PMS

Debt PMS strategies usually follow one of two approaches. Accrual strategies buy and hold bonds for their yield, taking credit risk for extra spread. Duration strategies trade longer bonds to profit from expected rate cuts, accepting price volatility. Because the client holds each bond directly in her demat account, interest is taxed in her hands at slab rates, and the manager's quarterly report lists every security with its rating and yield. A distributor should check the rating mix and the duration of the strategy before matching it to a client who wants stability.

The two numbers to carry forward are the price formula and the duration shortcut. Between them they answer almost every fixed income calculation the exam sets.