Corporate bonds are a tool for investment issued by corporates and banking/non-banking entities. The capital raised through the bonds is utilized by these entities to run their operation and/or for capital investment. Corporate bonds generally provide a higher rate of interest as compared to government bonds and fixed deposits. However, a number of factors are to be considered before investing in these bonds, one of which is the impact of changes in interest rates.
Corporate bonds generally provide a higher rate of interest, if compared with other fixed-income instruments like fixed deposits, government bonds and debt mutual funds. Many of these bonds can even be liquidated in the secondary market, thereby providing the investors the option to take an early exit without incurring any kinds of penalties, and with minimal charges (mostly transactional and taxation).
Corporate bonds also provide the option to receive monthly/quarterly/annual coupon payments. This enables the investors to recover some part of the capital even before maturity, thereby reducing the risk involved.
Returns in corporate bonds are a function of two kinds of risks involved – credit risk and interest rate risk. Credit risk depends on the worthiness of the entity issuing the bonds. Corporations that are deemed risky generally issue bonds with high-interest rates, while those that are considered safe are able to raise funds at lower rates.
On the other hand, interest rate risk is the variability in bond returns due to interest rate fluctuations. To understand more about this, we need to study the relationship between bond pricing and interest rates first.
A corporate bond has four factors associated with it – bond price, tenor, coupon rate and yield to maturity (YTM).
Too much information, is it? Let us try and understand with an illustration.
Suppose a friend took a loan of INR 5 lakh at 10% per annum for 5 years from you, and issued bonds in return, each with a face value of INR 1000. By that logic, you would have received 500 bonds from him. This means you were issued 500 bonds from your friend, at a coupon rate of 10% per annum, and a YTM of 10% as well.
However, you are still not satisfied with the deal. You wanted a higher coupon, as it would have helped you meet your expenses. Now, let us assume that you receive an offer from another friend on the same day when you loaned the money. The other friend is willing to purchase that loan from you by paying you INR 4.7 lakh, and offers you a new bond which pays 12% per annum for 5 years. Now, if you were to take up your other friend’s offer of cutting your investment down to INR 4.7 lakh and investing in the 12% issuance, your coupon will now become 12% per annum, while your YTM will also be 12%.
Do you see how the YTM has fluctuated as interest rates changed?
Also, let us not forget, your friend now holds 1000 bonds at a price of INR 470 per bond! This can be considered as the current market price of that bond.
So, what has happened in this illustration? As interest rates rose –
So, in effect, while you ended up taking a haircut in your investment amount by selling your bonds at a lower price and investing in a higher coupon bond, your cumulative cash flows will remain the same if you choose to hold the bonds till maturity.
The price of a bond has an inverse relationship with interest rates, while YTMs are directly correlated. This means, as interest rates go up, the price of bonds goes down, and yields surge. This effect is more predominant on longer tenor bonds.
All we need to remember is the following –
How will all this information help an investor to make better investment decisions? Let us find out.
Just like most things in the economic and financial world, interest rates are cyclical in nature. However, for a bond investor who is hunting for opportunities to generate an alpha in the portfolio, knowledge about interest rates can actually help a lot. They can choose to go for short-tenor bonds when interest rates are low so that the impact of rising rates does not hurt their bond prices later. Once interest rates are significantly up, the investor can switch over to long-tenor bonds, and voila!
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