Last year saw a marked increase in bond investments by individuals. Assets under management for debt-oriented mutual funds that invest in bonds (along with other securities) increased 40% between December 2015 and December 2016. As attention around interest rate cuts heightened, transaction volume for the retail segment for corporate bonds spiked to 110 billion securities on BSE (53% market share for the month) in September last year compared to an average of around 40 billion in the months prior, before dropping again .
Have you ever wondered what it takes to buy a bond directly from the market instead of applying through a public offer? This is not the same as buying stocks, where you are only considering price rise in a fixed time period. There are some key parameters that you need to be well-versed with before you are ready to trade or transact in bonds in the secondary market.
Price yield equation
Buyers need to be aware of two primary aspects, market price and yield. Market price is what is quoted on an exchange for buying or selling, and the yield shows what you earn every year by holding the bond. The latter is calculated by dividing the annual coupon or interest rate by the market price. Stocks are bought with the expectation that price rise will lead to profits. In bonds, however, buy price is not always lower than the face value of the bond that you get back at maturity. What really matters is the yield.
Bond prices rise when yields fall, and vice versa. For example, a bond issued at Rs100 with a 10% coupon and maturity of 2 years is sold at the end of year 1 at Rs101. This is a yield of 9.9% and makes for 11% return (Rs1 on the price + Rs10 coupon). At the end of the next year, the buyer gets back Rs100 principal and Rs10 as coupon, but that is not a return of 10%, rather it is 9%, because you paid Rs101 to acquire the bond. If you had bought when the yield was low, chances are you won’t be able to profit much as a rising yield means lower prices. If the trend is for yields to move lower, then the opposite is likely to occur. R. Sivakumar, head-fixed income, Axis Asset Management Co. Ltd, said, “Bond price does not tell you anything on its own. There is a clear relationship between past returns and future returns. If you are looking to benefit from a trade, buy when the yield is high with the expectation to sell when it is low.” This is easier said than done as bond yields depend on other factors like liquidity and ratings.
Liquidity
Ashish Chadha, a Gurgaon-based mutual fund distributor, said, “Retail investors need to be careful while buying bonds directly as the probability of losing money is high. Most bonds are not liquid, which means that when you want to exit, you put in a trade but you may not get a fair price.” You can buy bonds in the secondary market through a broker, digitally or through your bank, which will deposit the bond in your demat account.
Through the bank, you may have access only to the bonds that the bank holds and is willing to sell to you. At the time of exit, you don’t have to sell back to the bank; you can also sell on the exchange through a broker.
While daily volumes have moved upwards, the overall liquidity in the market is still low. Moreover, the interest rate sentiment can be a trigger for trading, which then impacts transaction volume differently each month. Vineet Arora, executive vice-president, ICICI Securities Ltd, said, “In our interface, where bond liquidity is a concern, only limit orders (price is specified) are taken rather than market orders. One can lose 1-2% immediately if the bond is illiquid and a market order is placed.”
Credit Rating
Another important parameter that determines yields and hence, price, is credit rating. In the formal debt market, if there is risk of repayment, the yield for the bond is expected to be higher. You want to earn more where the probability of loss is higher. But if the risk plays out and the issuer defaults, you may get nothing back. In stocks, you can sell and recover some of your money. But with bonds, due to limited liquidity, you may not be able to sell a distressed bond in the secondary market. And if the issuer does not have the means to repay you, it’s a total loss. “Investors have access to all credit rating details for each bond. A lot of retail and HNI (high net worth individual) activity happens in tax-free bonds. Many retail investors sell if they are looking for an early exit from these long-tenure bonds,” said Arora.
Tax-free bonds mostly come with AAA or AA rating; they carry minimal credit concern. The rating is given in the details available on online platforms, but without understanding the financial situation of the company it is not advisable to rely only on the rating. Whether you are buying online or offline, buying bonds in the secondary market requires in-depth understanding of the market, a view on the interest rate trend and skill in security selection. Take the mutual fund route if you are uncertain about your ability to execute this trade.
