Interest rates and fixed income securities

Debt Long-Short and Hybrid Long-Short strategies live or die by interest rates, and Module 3 of the exam gives interest rate derivatives about 20% of the marks. Before you can price a bond or hedge it with futures, you need the vocabulary of rates and the instruments they attach to. This chapter builds that base with Indian market examples.

What an interest rate is

An interest rate is the price of money over time: what a borrower pays a lender per year, expressed as a percentage of the principal. It compensates the lender for three things: deferring consumption, expected inflation, and the risk that the borrower will not pay. The rate on a government security is the risk-free rate for that maturity; every other borrower pays a credit spread on top.

Simple interest is charged only on the principal. Compound interest is charged on principal plus accumulated interest, so the compounding frequency matters.

Banks quote deposit rates as nominal annual rates but usually compound quarterly, which is why the maturity value on a fixed deposit receipt is a little higher than the headline rate suggests. The nominal rate is the quoted figure; the effective annual rate accounts for compounding. The real rate strips out inflation: approximately nominal minus inflation, or exactly (1 + nominal) ÷ (1 + inflation) − 1. With an 8% nominal rate and 5% inflation the real rate is 2.86%, not 3%.

Policy rates and the money market

The Reserve Bank of India sets the repo rate, at which banks borrow overnight from RBI against government securities. The Standing Deposit Facility rate (floor of the corridor) is what RBI pays banks for parking surplus; the Marginal Standing Facility rate (ceiling) is the emergency borrowing rate. The Bank Rate is the penal rate for shortfalls in reserve requirements. The Monetary Policy Committee reviews the repo rate every two months. Changes in the repo rate pass through to the whole yield curve, which is why bond funds and interest rate futures move on policy days.

The money market trades instruments of up to one year: call money (overnight interbank lending), Treasury bills (91, 182 and 364 days, issued at a discount by the government), commercial paper (corporate, 7 days to 1 year), certificates of deposit (bank-issued), repo and reverse repo between market participants, and tri-party repo. The overnight benchmark is MIBOR (Mumbai Interbank Offered Rate), published by FBIL from actual call money trades; it is the floating leg of the overnight index swap you meet in Chapter 13.

Bonds: the parts and the issuers

A bond is a loan split into tradable pieces. The face value (₹100 for G-Secs) is repaid at maturity; the coupon is the annual interest as a percentage of face value, paid semi-annually for Indian government securities. The price is quoted per ₹100 of face value and moves inversely to market yields. Issuers, from safest to riskiest: the central government (dated G-Secs, 1 to 40 years, and T-bills), state governments (State Development Loans), public sector undertakings, banks and corporates. Corporate bonds carry a credit rating from CRISIL, ICRA, CARE or India Ratings; AAA is the top grade, BBB− is the lowest investment grade, and anything below is speculative.

Other structures you should recognise: zero coupon bonds (issued at a discount, no coupons), floating rate bonds (coupon resets with a benchmark), inflation-indexed bonds, callable and puttable bonds, and perpetuals such as bank AT1 bonds.

Measuring yield

• Coupon rate: fixed, on face value. Says nothing about return at today's price.
• Current yield = annual coupon ÷ market price. A 7% bond at ₹95 has current yield 7.37%.
• Yield to maturity (YTM): the single discount rate that equates the present value of all remaining cash flows to the price. It is the return if the bond is held to maturity and coupons are reinvested at the YTM. Chapter 10 computes it.
• Discount yield for T-bills: T-bills pay no coupon; the yield comes from buying below face value.

A 91-day T-bill bought at ₹98.20 yields (100 − 98.20) ÷ 98.20 × 365 ÷ 91 = 0.01833 × 4.011 = 7.35% annualised. This is a money market (actual/365) convention, not a compound rate.

Risks in fixed income

Interest rate risk: prices fall when yields rise; the longer the maturity and the lower the coupon, the bigger the move. Reinvestment risk: coupons may have to be reinvested at lower rates. Credit risk: the issuer may default or be downgraded. Liquidity risk: a wide bid-ask spread on an illiquid corporate bond. Inflation risk: fixed coupons lose purchasing power. A debt mutual fund or a Debt Long-Short SIF strategy carries all of these; the SIF's extra tool is the ability to short interest rate futures to offset the first one.