In a span of 10 years, starting with the global financial crisis (GFC) and to the more recent issues pertaining to credit risk in the shadow banking industry led by the IL&FS crisis (of 2018), fixed income investors have had a steep learning curve. They have evolved from the idea that if the cash inflows are fixed in nature (fixed interest rates) then there is very little or no risk in the investment instrument.
The current investment landscape has clearly exposed these fallacies. During this ongoing turmoil, investors have been sensitised to the idea of loss or lower income in fixed income schemes. The basic concept of the relationship between the price of a bond and yield has become clearer. Spreads between differently rated papers are now being demystified.
Revisiting the basics
While investing in fixed income funds, one should be aware of the foremost relationship between the yield of a bond and the price of a bond. Bond prices are inversely related to bond yields. As the yield of a bond decreases its price increases and vice versa. This movement of yield is driven by various microeconomic and other parameters. In the current economic conditions, most investors are gravitating towards government bonds as these are risk free. The higher demand for these bonds is leading to an increase in prices and consequently dampening yields. The yields of these bonds are also dependent on the interest rate policy of the Reserve Bank of India (RBI). The RBI has been easing interest rates in a bid to revive the economy since February 2019. The 10-year bond yields are also an indication of the prevailing interest rates in the country. The yields on government bonds is the interest rate the government pays for raising debt.
The second important concept to understand is yield spreads. Government bonds are a gold standard in fixed income investing. They are backed by the government and are as such considered risk-free. However, those bonds that are not issued by the government usually tend to carry a higher level of risk. The difference in yield between government securities and corporate bonds of the same tenure is called a spread. A corporate, basis its balance sheet, financial strength and other parameters will be given a credit rating e.g. AAA, AA+, AA and so on. The spread is what investors demand to compensate them for the higher level of risk that non-government bonds represent. For example, assume that a 10-year government bond is trading at 5%. This becomes the floor for all bonds with a 5-year tenure. Now, a AAA 10-year corporate bond might be available in the market for 6.50%. The 50 basis point difference between the two bonds is the yield spread or the compensation for carrying the additional risk. These spreads are available across the rating spectrum and tenure. The lower spread indicates better times and higher spreads indicates volatile times and lower confidence in corporate bonds. As one goes down the credit curve the spreads tend to increase as the risk becomes higher. Investors have the option to invest at various levels on the risk-return spectrum. For example, investors who are looking for yields higher than those offered by government bonds but are not comfortable with taking higher risk can consider investing in the Bharat Bond ETF. This is basically an exchange traded fund that invests in a portfolio of AAA-rated bonds of public sector entities. Such an investment can offer good returns and comes with potentially higher safety as it invests only in public sector bonds.
Thus, when you invest in bonds, look out for these two relationships to determine the kind of risk you are assuming and whether it is commensurate with the returns being generated. However, many investors will tell you that choosing the right fixed income investments can be highly challenging. As an investor, it may be difficult to keep track of various underlying parameters that may impact the movement of the bonds and therefore, the portfolio. Your financial advisor can guide you through the fixed income market and help you assess the risks associated with these securities so that you can make optimal investment decisions.
