Saibal Biswas: let me explain this with an example. Suppose a government debt paper costs Rs 100 with a coupon rate of 7 per cent. In the meantime, suppose the interest rate falls. This means that new debt papers will carry a coupon rate of 6 per cent (say). This will lead to a situation where the 7 per cent bond will attract a premium, as no one else in the market will be able to offer 7 per cent bonds. When interest rates go up in the reverse scenario, what is the effect on debt papers? Suppose I have the same 7 per cent debt paper, while in the market such papers are sold at 8 per cent, then my debt paper will be sold at a discount. It is clear from the example that when interest rates go up, debt papers become discounted, that is, their prices go down. Similarly, if interest rates go down, debt papers become more expensive. Whatever the coupon rates, the price depends on the rise or fall of interest rates.
Suparna Pathak: Let me get this clear. Suppose I buy a bond, I can think of them as fixed deposits, at seven per cent. Now if I do not sell it, what happens to the relation between coupon rate and interest rate?
Saibal Biswas: if I do not sell and hold on to it till maturity, then I will get seven per cent only. But if we want to evaluate, that is arrive at the “mark to market”, that is to find out what should be the value of the debt paper according to the market, then all these factors of discount and premiums will come into play. But if I hold it till maturity like a fixed deposit, then I will only get the coupon.
Suparna Pathak: Let me try and understand it in layman’s terms. Suppose I buy a debt paper at Rs 100 which carries a 7 per cent interest. That is the coupon is 7 per cent, which means if I do not sell it, I will continue to get 7 per cent. Now the interest rate becomes 6 per cent in the market. Now suppose someone approaches me to buy the bond. Now if he buys the bond at Rs 100 from me, he will be entitled to an interest that is above the market rate. Now the logic is, as the market entitles you to 6 per cent and as you will be getting seven per cent if you buy from me, you will also have to shell out more. That is why, if the interest goes down, the price of bonds goes up. The opposite also holds true.
Saibal Biswas: Exactly
Suparna Pathak: How should one look at the prevailing cost of interest for buying bonds? Suppose I want to choose between equity and bonds. Suppose the return on equities is 6.5 per cent and the rate of interest in bonds is 6 per cent and someone advises me to invest in bonds. Why would they give such advice?
Saibal Biswas: Look there are two things here. Bond is like a fixed deposit. Its asset class is also different. Its risk profile too is completely different from equity. Equity investments carry much higher risks, while a bond, acting like a fixed deposit also carries a much lower amount of risk.
Where do we buy our bonds from? From the Government of India, State Governments – Corporates also float bonds but they are relatively riskier though their risk profile is unlike that of equity.
Suparna Pathak: “Their risk profile is unlike that of equity”, please explain.
Saibal Biswas: The stock market's volatility is much more pronounced with steep ups and downs. Now in a bond with a coupon rate of 7 per cent, if you hold on to the end, you will get seven per cent for sure. So, you can rest assured about the return. Equity cannot give you such a surety about the return, though, in the long term, it tends to be more.
So, when you are buying bonds, you are buying them because of the asset class in which bonds are in your portfolio, you will buy them if there is a need for such an investment in such a class. So, it is not correct to say that you are buying bonds against that of investing in equity – you are buying bonds because of their value proposition because it is needed in your portfolio.
Suparna Pathak: What you are saying, and we have talked about this in the past, is that the risk must be spread out in the portfolio. High risk for high gains, medium risk for medium gains. Low risk for relatively low gains. I have to fit my bond investments in this scheme of things – keeping in mind that as the risk in terms of bonds is low, the return is also comparatively steady. Is this what you are saying?
Saibal Biswas: Exactly, exactly.
Suparna Pathak: Today we have seen why the bond prices go up and down with the movement of interest rates. We have also seen how we can fit in bonds to address our individual risk profiles. That is, what will be the position of bonds in terms of risks within the portfolio?
We will discuss the importance of one’s age in stock market investing.
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Saibal Biswas: I think the next episode will be an important one as young people always want to know things like what is the right age to enter the stock market, where and when to invest, and such things – watch the next episode, for the answers.
Suparna Pathak: namoshkar.
Takeaway
Invest in bonds to balance the risk of your portfolio.
