Saturday, 4 January 2014

Debt: Interest Rate Risk

All bonds are subject to interest rate risk — whether insured or government guaranteed.

This post is a partial explanation as to why Indian debt funds that invest in long term debt instruments crashed in July 2013.


From FINRA.ORG:, ©2014 FINRA. All rights reserved.

Many factors impact bond prices, one of which is interest rates. A maxim of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is known as interest rate risk. But just as some people’s skin is more sensitive to sun than others, some bonds are more sensitive to interest rate changes than others. Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates.

The higher a bond’s duration, the greater its sensitivity to interest rates changes. This means fluctuations in price, whether positive or negative, will be more pronounced. If you hold a bond to maturity, you can expect to receive the par (or face) value of the bond when your principal is repaid, unless the company goes bankrupt or otherwise fails to pay. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. For instance, if interest rates were to rise by two percent from today’s low levels, a medium investment grade corporate bond (BBB, Baa rated or similar) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. A similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a loss in value of 26 percent. The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.

Duration has the same effect on bond funds. For example, a bond fund with 10-year duration will decrease in value by 10 percent if interest rates rise one percent. On the other hand, the bond fund will increase in value by 10 percent if interest rates fall one percent. If a fund’s duration is two years, then a one percent rise in interest rates will result in a two percent decline in the bond fund’s value. A two percent increase in the bond’s fund value would follow if interest rates fall by one percent.

Variables such as how much interest a bond pays during its lifespan as well as the bond’s call features and yield, which may be affected by changes in credit quality, play a role in the duration computation. Maturity—the length of time before the bond’s principal is repaid—also plays a role.

Math aside, once you know a bond’s or bond fund’s duration, you can predict how it will react to a change in interest rates.

Image source: SEC.GOV

Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates.The higher a bond’s duration, the greater its sensitivity to interest rates changes.

Image source: SEC.GOV

So it follows that debt Mutual Funds which invest in short term and ultra short term instruments, and Liquid Funds, which invest only in instruments that have a maturity period of less than 91 days, have less INTEREST RATE RISK, as compared to Funds that invest in long term debt instruments.

Long term funds, dynamic bond funds, GILT funds, all have high interest rate risk.

From Kotaksecurities website:


Non Convertible Debentures

An NCD (Non Convertible debenture) is essentially a debt instrument with a fixed tenure that pays a certain rate of interest monthly, quarterly, annually or at the end of the tenure. The money invested is returned either over the tenure of the investment or at the end of the tenure (referred to as bullet payment). These are certificates issued by companies to raise funds through the public issue. These instruments cannot be converted into equity shares and usually carry higher interest rates than the convertible ones.

According to a circular issued by RBI NCD means:

Non-Convertible Debenture (NCD) means a debt instrument issued by a corporate (including NBFCs) with original or initial maturity up to one year and issued by way of private placement;
Corporate" means a company as defined in the Companies Act, 1956 (including NBFCs) and a corporation established by an act of any Legislature

In India NCDs shall not be issued for maturities of less than 90 days from the date of issue and NCDs may be issued in denominations with a minimum of Rs.5 lakh (face value) and in multiples of Rs.1 lakh. An eligible corporate intending to issue NCDs shall obtain credit rating for issuance of the NCDs from one of the rating agencies, viz., the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd or such other agencies registered with Securities and Exchange Board of India (SEBI) or such other credit rating agencies as may be specified by the Reserve Bank of India from time to time, for the purpose.

Advantages of investing in NCDs:

Better Returns: NCDs in the past have offered interest rates which were quite attractive as compared to interest on other fixed-income options. While yield on redemption of Tata Capital NCD issue was 11.57 -12%, effective yield of Shriram Transport NCD was in the range is in the range of 10.75-11.50% which compares favorably with term deposits (TD) of banks. India info line is offering interest rate of 11.7% per annum for all options, except the one meant for individual investors putting their money for five years, where the rate offered is higher at 11.9% per annum.

If you happen to fall in the highest tax bracket (30.9%), your effective post tax returns will be 7.95 per cent based on rate of interest of 11.50% per annum. And if you're in the middle tax bracket (20.6%), return after tax will work out to be 9.13 per cent p.a. based on interest rate of 11.50% per annum. So, right now, NCD seems to be quite attractive investment option among debt instruments given that after-tax returns are around 8% for an investor in the highest tax bracket. However, in future companies might lower the yield based on the interest rate movement and debt market scenario.

No Tax deduction at source: Unlike bank FDs or corporate FDs, there is no tax deduction at source (TDS) on NCDs offered in DMAT mode and listed on a stock exchange as per section 193 of the IT Act. This, however, does not mean the investor does not need to pay any tax on the interest earned. Income tax on the interest income will have to paid at the time of declaring one's income.
Higher Safety: Unlike corporate FDs which are unsecured, NCD issues by NBFCs are secured debt (NCD's are 100% secured by assets of the company). Furthermore, both the NCD issues have received good credit rating. However, this doesn't guarantee 100% safety. Default risk still remains although very slight. But, default risk remains even in case of Bank FD's beyond Rs 1lakh.
Good Liquidity: NCDs offer good liquidity due to Stock Exchange listing (However listing does not guarantee liquidity). If you would like to go for premature exit, you can do it in two ways:-

Sell on the NSE
Exercise put option, if available.

However, remember that exiting through secondary market (NSE) entails interest rate risk. If the interest rates fall, the value of NCD will rise and in an environment of rising interest rates, the value of NCD's may fall below face value. But if you plan to hold it till maturity, then there is no-risk due to interest fluctuations.

Furthermore, there is also liquidity risk because Indian debt / bond markets are highly illiquid (less frequent trading and insufficient volumes). So, if you plan to sell NCDs before maturity by selling on the secondary market (NSE), remember that you might not be able to do so because of fewer buyers.

So we can say that for investors looking to park their money for long period, NCD is a good mode of investment, given that post-tax returns come to around 8% (for those who in the 30% tax bracket). Those in lower tax brackets can get even higher returns. Such instruments carry very low credit risk. Indeed, the NCDs have been rated 'LAA+' by ICRA, indicating high credit quality and low credit risk, and CARE AA+ by CARE, indicating high safety for timely servicing of debt obligations.

However, investors should also keep in mind that they may not get the right price on the NCD if they try and get out by selling it on the stock exchanges in the short term.

(1) Reserve Bank of India
(2) DNA
(3) Indian Express


What's the difference between NCDs & FDs?

Following are the differences between a NCD and a fixed deposit

Safety: While NCDs are secured debt, corporate FDs are altogether unsecured and bank FDs are secured to the extent of Rs one lakh only.

Taxation: There is difference in taxation aspect also. In addition to interest income, there can be capital gains if you sell the NCD before maturity. However, unlike FDs, there is no TDS in case of NCDs.

Interest rate risk: Unlike FDs, NCDs carry interest rate risk due to changes in market interest rates.

Why only NBFCs are issuing NCDs while manufacturing companies prefer issuing FDs?

Because some NBFCs are not allowed to issue fixed deposits, please note that the companies which are registered as 'non-deposit taking NBFCs' are not allowed to issue Public deposits / Fixed Deposits as per RBI guidelines.

Is DMAT account necessary for investing in NCDs?

Yes, a DEMAT account is necessary because all the recent issues of NCDs were compulsorily in the dematerialized form.

Is PAN also mandatory?

Yes, quoting PAN number in the NCD application form is compulsory irrespective of the amount involved as per SEBI guidelines.


Sources and recommended reading:
3. India Bonds Streaming Rate.

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