There are two ways of getting returns from the “fixed income” or debt market.
1. Give a loan, which really means to make a fixed deposit or buy a bond or debenture and receive the interest rate (or “coupon”) promised on the deposit. A bank or company FD is in this category.
Bond and debenture are essentially the same things in the debt market.
2. Invest in a bond or debenture of a corporation or institution, or “Certificate of Deposit” of a bank, or government security (called “gilt” if issued by the Central Government). These are traded and this feature can provide interest, and in addition capital appreciation or depreciation (profit or loss on the current market value of the bond). This gain or loss on the value of a bond occurs in response to changes in interest rates in the economy.
‘Certificate of Deposit’ is simply a tradable bank fixed deposit (FD). The liquidity of an FD is in either premature withdrawal (“breaking up the deposit”) or taking a loan against the FD.
The “Fixed Income” market actually does not provide a fixed income, except in an FD, or in a bond where the market price variations are ignored. The interest paid out on investment is what it “yields”, or provides as returns for the amount invested. The bond pricing is based on its “Yield-to-Maturity” (YTM), for its risk rating (credit rating) and time till redemption. A bond invested with the objective of ignoring any price fluctuation will provide the YTM at the time of purchase irrespective of market fluctuations, in the absence of default by the issuer.
In the panic following the 9/11 (September 11, 2011) incident of airplanes crashing into the World Trade Centre, the Indian 10 years benchmark 11.50% G-Sec crashed from about Rs. 132 to about Rs. 107 in less than a week. Over the next week, the price bounced back up. Effectively during the fortnight, the yield on the bond varied, but at every stage, the bond buyer was guaranteed that the capital invested (even at Rs. 132 on a bond with the face value of Rs. 100), as well as the returns at the YTM, would be received by her. The ‘guarantee’ comes from the certainty that a government does not default on its domestic borrowings.
Reducing the risk of price fluctuations that occur from the current time to the final maturity of the bond and return of the face value also provides opportunities for earning profits. Buying longer-term instruments when interest rates are expected to come down, or liquidity goes up is profitable. Conversely, having very short-term papers when rates are likely to increase, or liquidity tighten reduces risk and also contributes to the profitability of the bond portfolio.
On July 21, 2000, the RBI responded to a severe shortage of foreign exchange for imports and high inflation by increasing the bank rate by 1% and Cash Reserve Ratio by 0.5%, making money expensive and investments relatively unattractive. The move was anticipated a few months earlier itself. In response to the RBI’s tightening action some Debt Mutual Fund scheme NAVs dropped 15-20% that week. Fund Managers who acted earlier on the expectations had increased the cash and very short-term investments in their portfolio. Subsequently, the issue of India Millennium Deposits brought liquidity back to the markets by November the same year. Those who acted on this by increasing their portfolio maturity in anticipation of easier liquidity gained substantially. The best performing G-Sec mutual fund for the year gave returns in excess of 36%!
A crash in the equity market is the best way to turn aggressive speculators into long-term investors who believe that the fortunes of the company they have favored with their money will turn around someday.
Not so the bond market investor, unless the investment has turned to dust with a default by the issuer. We have seen that the investor will go away with at least the Yield-to-Maturity as returns as well as the face value of the instrument if held till the time of the bond being extinguished and money being returned.
The conservative investor in the fixed income market, having invested in the good quality paper would just bide her time, enjoying the desired yield on the investments.