Nobody loves your money more than you do

In the previous two articles (see related articles) we had shown how bonds as an asset class have outperformed in the last few months of 2008. However, our objective never has been to give tips to investors; we instead believe in educating investors and making them self-reliant. Today we discuss some bond basics.

Let us say I approach you for a Rs 100 loan for one year period and I promise to pay you 8 per cent as interest on the same (ie I approach you with a debt paper which has face value of Rs 100, maturity of one year and it pays interest of 8 per cent). This means that if you invest Rs 100 today (and buy the paper), you will get Rs 108 after one year (as I will pay you Rs 8 interest as well as repay your principal of Rs 100).

Conversely it means, if you want Rs 108 after one year, then you need to invest Rs 100 today for one year, as your money will be growing at 8 per cent per annum.

In bond terminology, the Rs 100 which you give today is known as the present value of future cash flow which you will receive; ie Rs 108. You have learnt this in Class VIII; it's simple mathematics.

If this is clearly understood, then let us assume that interest rate falls to 7 per cent immediately after you give me Rs 100.

Now you have got an asset in your hand (the debt paper), which delivers higher returns (8 per cent) than the prevailing market rate (7 per cent). Obviously, if you wish to sell this paper now, you will not be selling that paper to anyone at Rs 100, but at a rate slightly higher than Rs 100. But why will this happen, you may ask?

As you have a paper, which delivers higher returns than comparable papers, you will charge a premium in case you want to sell this paper -- that's logical.

If anyone invests Rs 100 today in some paper, other than the one you have, he will get only Rs 7 after one year (as rates have now fallen to 7 per cent); so how can you sell your paper to him at Rs 100, when it will give him Rs 8 as interest after one year? You will obviously ask for some price higher than Rs 100! How much higher?

The paper will give you Rs 108 after one year. This has not changed -- we had mentioned in the previous article that the face value and the coupon of a bond paper does not change -- however the rate at which your money grows has changed.

Earlier you money was growing @ 8 per cent per annum, now it is growing at 7 per cent per annum. So, if an investor wants the same amount (Rs 108) after the same period of time (one year), then obviously s/he will have to invest more today to reach her/his target, as now her/his money will be growing at a slower pace.

If you do some quick calculations then you will have to invest Rs 100.93 today to get Rs 108 after one year, if interest rates were to fall to 7 per cent from 8 per cent. Thus you will sell the paper at Rs 100.93 and not Rs 100.

What does this mean? This means: when interest rates fall, bond prices move up.

This is a very important logic in bond markets. Markets were expecting in July 2008 that going forward interest rates were all set to fall in a big way. Bonds started rallying (prices increased) from July itself, although interest rate cuts started only from October 2008.

Not many people must have advised you about bond funds in July 2008. by the money flowing into gilt schemes in December 2008 proved this -- after the rally was over (refer to the chart in the first article for both these points)!

As mentioned earlier, we are not at all into giving advice. We want you to learn. We want you to ask the right question: why this will happen, how to benefit from this fact, how to choose a bond fund, which bond fund will perform and which one will not are some questions which we will answer in the next article.

Till then seek these answers, and invest with knowledge. A knowledgeable investor is an empowered investor who can take independent decisions in a wiser manner; because nobody loves your money more than you do!

Disclaimer: This article is for information purposes only. Please do not take investment decision based on this article.

The author is a financial trainer for National Institute of Securities Market (Securities and Exchange Board of India's investor awareness arm), Bombay Stock Exchange and leading mutual funds. He runs a website www.moneybee.info and can be reached at ashutosh@moneybee.info.