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ABC of Fixed Income Investing - Understanding Yield April 28, 2011
Series on basics of investing in fixed income funds-Part II
Author : Niketa Agarwal


 ABC of Fixed Income Investing - Understanding Yield

Retail investors in India can be said to be reasonably well informed when it comes to investments in equities, real estate or even assets like gold or silver. The Fixed Income asset class, however, is not so well known. As a tool for diversification, and as a safe avenue for volatile times, understanding this class is important. Even experts agree that greater retail participation in the fixed income market in India will make it more robust.

Fundsupermart.com has always tried to draw notice to this asset class through various research and personal finance articles on the website. Taking this initiative further, we bring to you this series explaining basics of fixed income investments!

A. INTRODUCTION TO THE FIXED INCOME ASSET CLASS

B. Understanding YIELD

Returns on a fixed income security are calculated differently from other asset classes. In most other investments, the market value is the parameter based on which we evaluate returns. For example, if you purchased a stock in 2005 @ Rs. 200 per share and it is trading today @ Rs. 1000 a share, you would know that you had made an absolute profit of 500% on your investment.
With fixed income securities, your total return on investment is denoted by its “yield” which depends on:

  1. Face Value (how much you paid for it initially)
  2. Coupon Value  (rate of interest you receive periodically)
  3. Duration (when will the security be redeemed if you wish to hold it to maturity)
  4. Market Price (how much will you receive for the security if you were to sell it)

While the face value, coupon rate and duration of a security cannot change once issued, its market price fluctuates with changes in market interest rates, which in turn affects the yield. The following sections explain how

CHANGING INTEREST RATES AND MARKET PRICES

Rising interest rates make the prices of fixed income securities fall, whereas when interest rates are falling, the market prices of securities rise. Let’s take an example:
A bond with face value Rs. 100, maturity of 3 years and a coupon rate of 10%is issued. The market interest rate at the time of purchase is 8%, and falling. The investment in this scenario promises to be attractive for the investor as it offers greater returns than the present market rate. The market price of this bond will therefore be higher than the face value.
Now, if the market rate increases to 10% in the second year of the investment, the bond no longer remains attractive and the market price drops down to Rs. 90.
Also note that the market prices of securities with longer time to maturity fluctuate more when interest rates change.

MARKET PRICE AND YIELDS

We saw how changes in the interest rates affect the market price of a security. When the market price changes, this affects the overall return on the security as well. With an increase in the market price, the yield on a security comes down; conversely, when prices drop, yields increase.


 



We continue the previous example, of the 3 year bond, coupon rate of 10%, face value of Rs. 100. Let’s assume that in the first year, when interest rates are falling, the market price of the security is Rs. 120. Interest income on the bond is Rs. 10 (based on coupon rate which does not change.)
The yield in the first year: 10/120*100 = 8.33%.
In the second year, the market price fell to Rs. 90. With interest income of Rs. 10, the yield is: 10/90*100 = 11.11%.

The following table clearly shows the inverse relationship between market price and yield:

Market Price

Interest Income

Yield

120

10

8.33%

100

10

10%

90

10

11.11%

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We would continue with the series. Watch this space for more...


Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website. Risk Factors: Mutual funds, like securities investments, are subject to market risks and there is no guarantee against loss in the Scheme or that the Scheme’s objectives will be achieved. As with any investment in securities, the NAV of the Units issued under the Scheme can go up or down depending on various factors and forces affecting capital markets. Past performance of the Sponsor/the AMC/the Mutual Fund does not indicate the future performance of the Scheme. The name of the Scheme does not in any manner indicate the quality of the Scheme, its future prospects or returns. Please read the Statement of Additional Information and Scheme Information Document carefully before investing.



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