Presentation on Debt Market

IDFC Mutual Fund

 Debt and Interest Rate
• Investment Horizon ( IH) = Time during which
investor would invest;
• Remaining Maturity (RM) = Time remaining till
the issuer of the instrument pays to the holder .
• If IH< RM , the investor has price risk and debt
behaves in the same manner as equity.
• IH= RM and if the issuer is government , the
investor does not assume any price risk.
• IH>RM then reinvestment risk is present.
 IH < RM
• Investor would gain if interest rate goes down
for all debt instrument except one ;
• The following rules are followed in such
situation :
– Price and Yield To Maturity are inversely related :
• YTM is synonymous with interest rate for the remaining
maturity of the debt instrument;
– Change in price is directly proportional to :
• Both duration and modified duration ;
• Convexity ;
 IH < RM
• Both duration and Modified duration is :
– Directly proportional to tenure or remaining
maturity of the instrument ;
– Inversely proportional to coupon and YTM of
the instrument;
• This strategy is followed for bond
management .
 IH< RM
Interest Rate is expected to go down

Price would Long Higher Lower

go up Duration Tenure Coupon
bond would
be desirable Lower YTM
Interest rate to go up

Price would Short Lower Higher

go duration Tenure Coupon
down bond would Higher YTM
be desirable
 Key to prediction on interest rate
• The key to investment in debt fund is the
prediction on interest rate ;
• Several factors affect interest rate ;
– Inflation
– Growth
– Monetary policy
– Fiscal policy
– Government borrowing programme
 Broad Parameters for predicting
interest rate
Growth Rate Inflation Fiscal Deficit Likely
interest rate
Low High High Low

Low Low High Low

High Low High Status quo

High High Low High

 Total Money Supply

Money with
Central
Bank

Private

Govt
 Total Money Supply in
Higher Fiscal Deficit

Money with
Central
Bank

Private Interest rate goes up

Govt
 Total Money Supply in
Higher Fiscal Deficit
Money
with
Central
Bank
Govt
Private Private Placement
With RBI and
Govt interest rate goes
Down or remains
same
 10 Year G Sec Yield Trends ( %)

8.64
7.45
7.08
6.23 6.36
5.26

July-08 Septemb October- Decembe Febr March-09

er-08 08 r-08 uary-09
 Explanation ….
• Growth is down ;
• Inflation is down;
• Yield should go down ;
• But yield is going up;
• How to explain this ?
 Explanation ….
• More Fiscal deficit announced by
Government ;
• More Fiscal deficit means more borrowing
by Government ;
• More borrowing means less amount
available to corporate
• This is pushing yield;
 Movement of Yield for last 6 months

10.00
9.00
8.00
7.00
6.00 10 Yr
5.00 5 Yr
4.00 1 Yr
3.00
2.00
1.00
0.00
July-08 Septemb October- Decembe Febr March-09
er-08 08 r-08 uary-09
Open Market Operation ( OMO)
• RBI controls money supply by selling or
buying securities.
• RBI buying securities : RBI lending money
; Repo Rate -1 day
• RBI selling securities : RBI borrowing
money ; Reverse Repo Rate -1 day
 Repo Transaction

Money 100 Securities

RBI Bank RBI Bank

100+Repo Rate
Securities 105
 CBLO Transaction

Money 100 Securities

Bank/ Bank/ Bank/ Bank/

Non Bank Non Bank Non Bank Non Bank
100+CBLO Rate
Securities 105
 Call Money Transaction

Money 100 Call Receipt

Bank Bank/ Bank/

Bank
Non Bank Non Bank
100+ Call Rate
Call Receipt
 Impact of Repo Rate

MIBOR &CBLO

10 Yr G Sec

5 Yr G Sec

Repo
Rate

1 Yr G Sec
Correlation ( Apr 2000- Dec 2006)
RREP 1.00

Call 0.86 1.00

TB91 0.86 0.95 1.00

TB364 0.84 0.92 0.99 1.00

Yield10 0.78 0.88 0.96 0.98 1.00

 Way forward : My Personal View
Point
• More Yield means more borrowing cost by
Government ;
• More Yield means more MTM Loss by banks on
their investments ;
• Lower profit by banks ;
• Already hit by lower interest income due to
slowing down of economy;
• Banks are citing G Sec yield as alibi of not
cutting down further PLR :
– BOI Chairman and ICICI Bank MD & CEO ‘s views;
 Way forward : My Personal View
Point
• The ultimate aim is to reduce cost of
borrowing.
• RBI would purchase bond in the open
market .
• Private Placement of bond to RBI is
possible .
• FII in G Sec market can come.
• The 10 Yr bench mark yield should come
down .
 Way forward
• Short term , very volatile.
• Short term investment should be in money
market investment .
• From 1 month to 2 month :
– Portion in short term
– Portion in 5 Yr YTM
– Portion in 1 Yr YTM
• From 2 months to 9 months :
– Portion in 1 Yr YTM
– Portion in 5 Yr YTM
– More in 10 Yr YTM
 Corporate Bond
• Two factors in Corporate Bond YTM :
– Risk Free YTM
– Risk Premium
• Function of Credit Risk
– Would go up during recession due to downgrading

• The difference between these two YTM is

called Yield Spread.
 10 Yr G Sec , AAA Yield and Spread

14.00

12.00
10 Yr
10.00

8.00 10 Yr AAA Rate

6.00 Bond
Spread
4.00
2.00

0.00
July-08 Septe Octobe Decem Februa Ma
mber- r-08 ber-08 ry-09 rch-09
08
Asset Backed Securities ( ABS)

Asset Backed Securities in a general sense

CDO
Mortgage ABS in a
Backed Narrower
Securities Sense
( MBS) •Credit Card
Residential •Equipment
Mortgage •Student Loan
CLO CBO
Commercial •Music Royalties Loan owned Bonds
Mortgage By Traded in the
Bank Market
 Process of securitisation

Credit Originator /
Enhancer Servicer
Provides Credit Receives Loan sale Receives inflow
Enhancement Fund From reference
Transfer
Of Assets Issuer of
Trustee S.P.V. Underwriter
Principal Debt
And Interest Securities
Minus
Servicing Revenues from
Fees Debt Distribution
Securities Of
Disburses
Revenues to Debt Securities
Investors Investors
 Is investment in securitised asset
risky ?
• The investor may not know the quality of the
underlying assets.
• The investor is depending on the credit rating
assigned by the rating agency.
• If the underlying asset quality is bad but rating
is higher , investor incurs the risk .
• Under such situation, securitisation is definitely
riskier.
• Securitised instrument of Real Estate and
Finance companies are riskier as the underlying
asset is riskier by nature.
 IO and PO Securities

1500.00
1000.00 PO PO
Amount

500.00 IO
IO
0.00
Months

Time in Month
 PO Securities – Principal Rs
100000/-
• Total payments to a PO are fixed—
– all that is uncertain is the timing of those
payments.
– Prepayments are desirable because the holder
of the PO receives the money earlier.
– With interest rate decrease , the prepayment
probability goes up .
– So the investor would get the money faster .
– The price would go up .
 PO Securities – Principal Rs
100000/-
• A invests in PO for 120 months. Under normal
interest rate ( 10%p.a.) , the investor would get
back the money ( Rs 1,00,000/-) after 120
months.
• If the interest rate goes down , the loan borrower
would pay the money earlier as the same EMI
would close the loan earlier.
• So the investor would recover the same money
( Rs 1,00,000/- ) earlier.
• The price in the market should go up.
• PO and interest rate is inversely proportional.
 IO Securities – Interest amount of
Rs 58581 @ 10% p.a. for 120 months
• A invests in IO for 120 months. Under normal interest
rate ( 10%p.a.) , the investor would get back the money
( Rs 58581/-) after 120 months.
• If the interest rate goes down , the loan borrower would
pay the money earlier as the same EMI would close the
loan earlier.
• So the investor would recover lower amount of money
because interest amount would be lower . For example,
if interest rate goes down to 9% , the investor would not
get Rs 58581/- but it would get Rs 48,255/- . But PO
holder would get the amount of Rs 1,00,000/- but in 113
months.
• The price of IO would go down with interest rate .
 Interest Rate and Price
Instrument Yield going up Yield going down
would result in would result in
Price Price
Discounted Decrease Increase
Instrument

Coupon Bearing Decrease Increase

Instrument

Principal Only Decrease Increase

Securities

Interest Only Increase Decrease

Securities
 Interest Rate and Desirable
Instrument

Yield going up Yield going down would

Should result in result in buying
buying
IO Fixed Income, Discounted
Instrument ,
PO
 All recommended solutions are personal opinion of Prof
Praloy Majumder, author of this presentation . Mutual
fund investment is subject to market risk and investor must
use due diligence before choosing the investment plan
recommended here.
Situation I – Bearish Equity Market
, High Interest Rate , Low Inflation
and Low GDP growth rate
• For ultra short term investment ( with an
investment horizon of up to 120 days ) :
Preferable Liquid Fund and Liquid plus ;
• As we are not sure about the timing of interest rate cut; But
definitely interest rate would be cut in the immediate future;
• For short term investment ( with an investment
horizon of 120 days to 365 days ) : Gilt edged
fund of higher average maturity ;
• As interest rate is expected to come down , the higher
average maturity gilt edged fund would generate more
capital appreciation;
Situation I – Bearish Equity Market
, High Interest Rate , Low Inflation
and Low GDP growth rate
• For medium term investment ( with an
investment horizon between 1 to 2 years ) :
– More in Bond Fund ;
– Less in Equity Fund ;
• For long term investment ( with an investment
horizon of 2 years and above ) :
– More in Equity Fund ;
– Less in Bond Fund;
Situation II – Bullish Equity Market
, Low Interest Rate , Low Inflation
and High GDP growth rate
• For ultra short term investment ( with an
investment horizon up to 90 days ) :
– More in Equity Fund ;
– Less in Bond Fund ;
– Minimum in Gilt Fund;
• For short term investment ( with an
investment horizon of up to 1 year ) :
– More in Equity Fund ;
– Less in Bond Fund;
Situation II – Bullish Equity Market
, Low Interest Rate , Low Inflation
and High GDP growth rate
• For medium term investment ( with an
investment horizon between 1 to 2 years ) :
– More in Equity Fund but lesser amount compared to
first two types of investment pattern;
– Less in Bond Fund but higher amount compared to
first two types of investment pattern;
– Minimum in Gilt Fund;
• For long term investment ( with an investment
horizon of more than 2year ) :
– Equal amount in Equity Fund ;
– Equal amount in Debt Fund ;
Situation III – Bullish Equity Market ,
High Interest Rate , Low Inflation and
Moderate GDP growth rate

• For ultra short term investment ( with an

investment horizon up to 90 days ) :
– More in Equity Fund ;
– Less in Gilt Fund;
– Minimum in Bond Fund ;
• For short term investment ( with an
investment horizon of up to 1 year ) :
– More in Equity Fund ;
– Less in Bond Fund ;
Situation III – Bullish Equity Market ,
High Interest Rate , Low Inflation and
Moderate GDP growth rate

• For medium term investment ( with an

investment horizon between 1 to 2 years ) :
– More in Equity Fund;
– Less in Gilt Fund;
• For long term investment ( with an
investment horizon of more than 2year ) :
– Equal amount in Equity Fund ;
– Equal amount in Debt Fund ;
 Investment Advice- Conservative
and Passive Management
Total 1-3 3-9 9-18 18-24 More
Fund Months Months Months Months than 24
( Rs lacs) ( Rs lacs) ( Rs lacs) ( Rs lacs) ( Rs lacs) Months
( Rs lacs)
20 5 5 10

Investment Pattern
20 4 1 +4 1+10
Short Term Gilt Fund Equity
Debt Fund Fund
( 1yr
instruments ,
T bill,
CBLO )
 Investment Advice – Aggressive &
Active Management
Total 1-3 3-9 9-18 18-24 More
Fund Months Months Months Months than 24
( Rs lacs) ( Rs lacs) ( Rs lacs) ( Rs lacs) ( Rs lacs) Months
( Rs lacs)
20 5 5 10

Investment Pattern
20 4 5 + 10
Short Term Gilt Fund
Debt Fund
( 1yr
instruments ,
T bill,
CBLO )
 Key Take way from sessions
• Debt Fund behaves like equity fund in most of the cases .
Why ?
– Investment horizon is less than maturity of invested instrument
.
• Interest rate prediction is important :
– Increase in interest rate would reduce the debt instrument’s
value except IO ;
– Increase in interest rate is associated with :
• Higher inflation ;
• Higher borrowing by Government ;
• Higher MSS by RBI ;
• Point prediction is difficult but range prediction is more
realistic attempt.
 Key Take way from sessions
• If interest rate is going up , invest in short
maturity investment with matching
maturity and roll over till the interest
starts coming down.
• In times interest starts coming down ,
invest in gilt fund.
• For long term investment , invest in
Equity.