Case study of Long Term & Short term Bond Papers
Just knowing relation is not enough, knowing implementation of it is also important…
Now, we have understood the relation between market interest rates and bond price. Let us try to understand what happens with long term bond paper. If B invest in bond paper issued by A for three years and invests same with C for five years @ 8% coupon. If interest rate falls,…?
According to the inverse relation, with fall in market interest rates, there will be rise in bond price. In above case the bond price of A and B, will rise. Now at what rate this increment happens is questioning If market interest rate becomes 7%.
Three years Five years
FV 100 FV 100
Tenure 3 Tenor 5
Coupon 8% Coupon 8%
Market Rate 7% Market Rate 7%
Years 0 1 2 3 Years 0 1 2 3 4 5
PV1 7.476636 8 PV1 7.476635514 8
PV2 6.98751 8 PV2 6.987509826 8
PV3 88.16017 108 PV3 6.530383015 8
102.6243 PV4 6.103161696 8
PV5 77.00250738 108
From the above tables we can conclude that if B invest in A for three years, B will get the investment back after three years which if B reinvests he will get cash flows @ 7% instead of 8%. Where if B invests with C for five years then for five cash flows B will get higher rates than that of market.(where market interest rate has fallen.) so we can say as market interest rates are falling five years bond rate is rising more than three years bonds. And vice versa if market interest rates are rising then the five year bond will fall more than three year bond. To summarize we can make new statement here that “Long term bonds are more sensitive to market interest rates”.
For Bonds we saw two important relations, First one is “Bond prices are inversely proportionate to market price” and second one is “Long term bonds are more sensitive to the market interest rates”. The knowledge without implementation is of no use.
In day to day life all of us are fighting with inflation, RBI hiked interest rates consecutively for 13 times. Rupee is all time low at Rs.54 against US dollars. IIP numbers are minus for the quarter, growth rate is hard to achieve. We know to make it steady and ease the pressure RBI may lose some bps (basis points, 100 basis point = 1%) in near future. And if interest rates falls then bond price will rise, and according to the second relation long term bond paper will be more aggressive in raising its price. In last decade we have seen that one time one asset performs, and this is the time for long terms bond papers or GILT funds, in last 1 month these gilt funds have delivered ~ 4% returns, means annually almost 40% returns. Getting 40% returns may look unrealistic but the time when we are getting slaughtered in equity, there is a bull in bonds, all set for the run, ready with freshness, and still we are side lining. It is our tendency now a day, when crowd makes noise, we take the chance but this is the time where the silence is speaking louder than anything and welcoming us for the new rally.
So, when equity is in trouble and if we can understand this form of asset, then we can change the type of our investment and still make some handsome returns on it.
This is why knowing BONDS is important. Just make your doubts clear, Study regularly, track your investments, love your money clear your doubts and do not listen to so called Market Guru. Let us study regularly, read Financial paper, track RBI’s movements and decide the investment strategy. Just remember the law of thermodynamics and enjoy the gains. Till then rock the study’s and rule the investments.
Financial Consultant Stock Analyst & Columnist
Beta Money Management Services