2009 shall be the year of The Bond (market). Bonds have already started off the upward journey on the face of lackadaisical interest in equities and a speculative opportunity arising out of yields going up significantly in the past few months. Expected downgrades and fears of default had pushed up bond yields to high levels in the past few months. Added was fact that they yield on the benchmark 10 year Gsec paper, had climbed to a high of 9.5% in late July 08.
A bond or fixed income security is an instrument issued by a borrower with a certain interest rate (referred to as coupon rate), and a fixed maturity. Bonds are thus fixed obligations to return principal and make fixed tenor payments of interest to the holder of the bond. Long duration (more than one year) Bonds issued by the Government are often referred to as G-Secs or Gilts. Gilts are supposed to be the safest instruments and carry zero credit risk. Bonds are often tradable securities which gives rise to an opportunity to benefit from the change in prices of these bonds.
Bonds and fixed income securities are sensitive to various factors. Interest rates prevailing in the economy, risk premiums attached to different securities, often measured by their credit rating, and factors affecting demand and supply of bonds decide bond prices. Some other factors like liquidity risk also play a part. Lets consider how each of these affects bond prices.
Interest Rate Risk: Bond prices are inversely related to the interest rates prevailing in the economy. Lets consider a scenario where you make a FD with a bank at 8% pa for 5 years. After 6 months you realize that deposit rates have risen to 10%. A rational investor would break the old FD and tell the bank to make a new one at 10%. Now suppose instead of a bank FD you were really holding a tradable bond, with interest rates going up to 10% the 8% bond has become less attractive. This would reflect in the price of the bond, which would fall to a price so that the 8% coupon would work out to a yield of 10%. Thus the new price would be 8%/X = 10%. The new price thus would be Rs 80 representing a fall of Rs 20 from the original price of Rs 100. The same logic would apply if the interest rates fall, bonds carrying a higher rate become more attractive and their price would go up to come in line with the higher yields prevalent in the bond market.
Credit Risk: This simply put is the risk of default on the borrowings. Bonds issued by companies not perceived to be very safe would be issued at a lower price, thus making the yield attractive to investors. A Rs 100 bond with a coupon of 8% thus may be issued at Rs 96 thus making the yield 12% to the investor. Now if the outlook on this company falls further ie suppose its bonds are downgraded by the rating agencies, the prices would fall further (and yields would rise), thus resulting in a loss for the investor. Similarly the reverse would happen if there is a upgrade in the rating of the bond. Credit risk is sometimes reflected in the spread between government bonds and bonds issued by companies. So a widening yield spread between the benchmark 10 year G-Sec and AAA Corporate paper means that generally the markets believe there is a significant credit risk in corporates bonds.
Liquidity Risk: Bonds are traded in the secondary market which is not very deep. While G-Secs are actively traded securities, PSU and corporate securities are sometimes not actively traded. Liquidity risk represents the risk arising out of not being able to sell these securities when required. The holder of a bond may thus be forced to liquidate the security at a discount leading to a loss.
Some other factors affect the demand and supply of bonds and thus their prices. Fresh government borrowing represented by a higher supply of government bonds, changes in SLR ratio of banks, which is the percentage of deposits of banks that has to be held in Government securities and the speculative interest in bonds are some other factors affecting prices.
The last few moths of 2008 saw major volatility in the bond markets. In July 2008 the benchmark 10 year G-Sec (8.24% GOI, 2018) yield rose to a 9.5% in the face of rising interest rates in the economy. As the government’s focus shifts from controlling inflation by increasing interest rates to one of growth orientation marked by reducing interest rates, bond yields started falling. The 10 year G-Sec yield thus started it’s downward journey and reached a low of 5.44% in December returning huge profits to holders of these bonds.
The year 2009 also holds promise for the bond market. Lack of interest in equities would make it difficult to raise fresh capital from equities. Corporates would be forced to look at the debt market for their needs. Mutual Funds would become active and there are signs already, as the retail investor look towards options other than equity. My opinion is that the rally has only just begun and would continue to hold promise for better part of next year. What may not happen in a hurry is the yield contraction between corporate and government paper. There seems to be a wide spread opinion that all may not be well in the corporate bond market and some defaults are likely in the next quarter. Although the current spreads seem to have factored in the risk, actual defaults may further dampen spirits leading to a further expansion in spreads. While later in the year the fears may subside, the spread contraction theory may take a little while to take off. Personally I would prefer bond funds that hold government and PSU paper only.
Monday, January 5, 2009
Friday, January 2, 2009
Lesson From 2008
A long and terrible year has come to an end. For mutual fund investors, this has easily been the worst year ever. This is hardly surprising given the way stock prices have collapsed across the board.
The mainstream equity category of diversified equity funds halved investors' money, falling an average of 55 per cent during the year. This 55 per cent loss represents more than Rs 60,000 crore of losses for investors who had invested in diversified equity funds.
This was actually slightly worse than the two large-cap indices, the Sensex and the Nifty which are both down about 53 per cent during the period. This is unusual-the average diversified equity fund generally beat the indices by a wide margin.
The depth of the collapse in 2008 has led to a certain fatalism among fund investors. People have just thrown up their hands, figuratively speaking, and abandoned any attempt at looking more deeply into what went wrong and what went right. Or at least, what went more wrong and what went less wrong. The 55 per cent is merely the average of the funds. There's rather a large range hidden within this. The worst fund is down about 80 per cent and the best one just about 35 per cent. The 80 per cent is not really an extreme case-in all there are eight funds that are down by more 70 per cent. At the other end of the performance continuum, there are about 10 funds that fell 45 per cent or less. This is not a small difference. If you started the year with Rs 20 lakh, the worst fund would have reduced it to Rs 4 lakh and the best one would have reduced it to about Rs 13 lakh.
Of course, the above numbers apply only to the worst-case investors-those who made their entire investment a year ago. Hopefully, there are many mutual fund investors out there who have imbibed the correct mantra and have been around for a longer-term. Such investors will appreciate the fruits of choosing good funds better. Over the past three years, the best funds would have grown your 20 lakhs to between Rs 25 lakh and Rs 28 lakh while the worst ones would have shrunk that amount to around Rs 10-12 lakh.
The best part of the story is that differentiation between the better and the worse is as predicted. Funds that were more aggressive, that dabbled more in smaller companies and took more concentrated bets are the worst performers. In fact, the three worst funds of 2008 were in the top five in 2007. This slide from the very top to the very bottom is not unexpected. It holds an old, well-worn but fundamental lesson-mutual funds that do the very best in bull runs fall suddenly and sharply when the good times turn to bad. It's an inevitable side-effect of how equity fund managers generate excessive returns during bubbles.
In many ways, the real surprise of 2008 was how debt funds fared. Debt funds are supposed to be stable and conservative so these surprises came as a shock to their investors. While I've discussed debt funds in detail in past weeks, it must be pointed out that the crises faced by these funds during 2008 fall into two categories. Interest rate changes, while unexpected, are very much part of the game and will remain so. But the liquidity freeze in October and November was a structural problem that is unlikely to happen again.
All in all, 2008 may have been a terrible year, but given what happened in the underlying markets, it did follow a pattern. Moreover, it was a year that clearly points the way forward for fund managers and investors.
The mainstream equity category of diversified equity funds halved investors' money, falling an average of 55 per cent during the year. This 55 per cent loss represents more than Rs 60,000 crore of losses for investors who had invested in diversified equity funds.
This was actually slightly worse than the two large-cap indices, the Sensex and the Nifty which are both down about 53 per cent during the period. This is unusual-the average diversified equity fund generally beat the indices by a wide margin.
The depth of the collapse in 2008 has led to a certain fatalism among fund investors. People have just thrown up their hands, figuratively speaking, and abandoned any attempt at looking more deeply into what went wrong and what went right. Or at least, what went more wrong and what went less wrong. The 55 per cent is merely the average of the funds. There's rather a large range hidden within this. The worst fund is down about 80 per cent and the best one just about 35 per cent. The 80 per cent is not really an extreme case-in all there are eight funds that are down by more 70 per cent. At the other end of the performance continuum, there are about 10 funds that fell 45 per cent or less. This is not a small difference. If you started the year with Rs 20 lakh, the worst fund would have reduced it to Rs 4 lakh and the best one would have reduced it to about Rs 13 lakh.
Of course, the above numbers apply only to the worst-case investors-those who made their entire investment a year ago. Hopefully, there are many mutual fund investors out there who have imbibed the correct mantra and have been around for a longer-term. Such investors will appreciate the fruits of choosing good funds better. Over the past three years, the best funds would have grown your 20 lakhs to between Rs 25 lakh and Rs 28 lakh while the worst ones would have shrunk that amount to around Rs 10-12 lakh.
The best part of the story is that differentiation between the better and the worse is as predicted. Funds that were more aggressive, that dabbled more in smaller companies and took more concentrated bets are the worst performers. In fact, the three worst funds of 2008 were in the top five in 2007. This slide from the very top to the very bottom is not unexpected. It holds an old, well-worn but fundamental lesson-mutual funds that do the very best in bull runs fall suddenly and sharply when the good times turn to bad. It's an inevitable side-effect of how equity fund managers generate excessive returns during bubbles.
In many ways, the real surprise of 2008 was how debt funds fared. Debt funds are supposed to be stable and conservative so these surprises came as a shock to their investors. While I've discussed debt funds in detail in past weeks, it must be pointed out that the crises faced by these funds during 2008 fall into two categories. Interest rate changes, while unexpected, are very much part of the game and will remain so. But the liquidity freeze in October and November was a structural problem that is unlikely to happen again.
All in all, 2008 may have been a terrible year, but given what happened in the underlying markets, it did follow a pattern. Moreover, it was a year that clearly points the way forward for fund managers and investors.
AUMs back on track after 2 mths as big houses shore up funds
After witnessing two months redemption pressure and an erosion in assets under management (AUM), the Indian mutual fund (MF) industry seems to be clawing back on track. The AUM numbers released by the Association of Mutual Funds in India (Amfi) indicates that there has been an overall growth with larger players shoring up the numbers. Top fund houses like Reliance Mutual Fund, ICICI (ICICIBANK.NS) Prudential, Tata and SBI (SBIN.NS) Mutual fund have registered decent growth in their Asset under Management (AUM) for the month of December 2008. Country s top fund Reliance Mutual Fund registered a growth of Rs 2,392.24 crores or 3.53 and its AUM stood at Rs 70,208.10 crores compared to Rs 67,815.86 crores in the month of November. According to numbers disclosed by 22 of the 37 fund houses the overall AUM has increased by 4.67% in December over the previous month. Waqar Naqvi, chief executive, Tauras Mutual Fund said, The fund houses having exposure in the equity market have gained their AUM in the month of December, 2008 as the over all market has gone up by 10% during the month. The equity market has gone up positively in the December. Some of the fund houses have also gained their AUM with the inflow of money into their liquid funds. It can be mentioned that in the month of December the benchmark index, the 30-share Sensex (^BSESN) of Bombay Stock Exchange (BSE) gained 1,063 points or 12.03%. ICICI Prudential MF s AUM for the month of December stood at Rs 41,877.51 crores, increase by Rs 4,821.84 crores or 13.01%. While there are several fund houses which continued to face the heat of global meltdown. Edelweiss MF saw dip in their AUM at Rs 77.21 crores in December compared to Rs 164.79 crores in November a decrease of Rs 87.57 crores or 53.14%.
Wednesday, December 31, 2008
A third of equity funds below Rs 10
Sector data
124 funds below Rs 10
35 over three years old
Theme, tax and mid-caps suffer
That many stocks have plunged below their IPO prices isn’t surprising, as we take stock of markets in 2008. But did you know that mutual funds too have suffered the same fate? After the market rout, about one in three equity funds (124 out of 342 funds) today sport a NAV that is below Rs 10.
The surprising fact is that not all of these were new funds flagged off at the height of the bull market. As many as 93 of these funds are more than a year old, and as many as 35 of them have been around for more than three year
Investors usually shy away from funds with a higher net asset value; but it turns out they have fared better in the market crash.
Funds that sported unit values of less than Rs 10 fell an average 53.9 per cent this year, while those above Rs 10 fell by a lower 49.5 percent. But the gulf between the best and worst performing funds in the “sub-10” category was wide.
Birla Sunlife International Equity, contained its decline to 32 per cent, but the worst performer – JM Emerging Leaders – suffered a near-79 per cent erosion in its unit price.
The most-affected funds were theme or sector specific funds and tax-planning funds. Infrastructure and energy were key themes that witnessed a free fall this year.
New funds flagged off in the last 12-18 months saw their unit prices trimmed by 50-65 per cent.
Tax-planning funds too were prominent losers, thanks to several of them being biased towards mid-cap stocks. Even “contra” funds did not manage to buck the trend and lost between 42-70 percent.
One key lesson for the investor from 2008 is that if you are invested in theme funds, it may be best to quit when you are ahead.
If you can’t take an active approach, best to stick with plain vanilla diversified funds. Plus, a fund with a low NAV may be as risky as one with a higher NAV.
So before you rush to buy a fund at a “low” net asset value, evaluate it as you would evaluate one with a “high” NAV.
124 funds below Rs 10
35 over three years old
Theme, tax and mid-caps suffer
That many stocks have plunged below their IPO prices isn’t surprising, as we take stock of markets in 2008. But did you know that mutual funds too have suffered the same fate? After the market rout, about one in three equity funds (124 out of 342 funds) today sport a NAV that is below Rs 10.
The surprising fact is that not all of these were new funds flagged off at the height of the bull market. As many as 93 of these funds are more than a year old, and as many as 35 of them have been around for more than three year
Investors usually shy away from funds with a higher net asset value; but it turns out they have fared better in the market crash.
Funds that sported unit values of less than Rs 10 fell an average 53.9 per cent this year, while those above Rs 10 fell by a lower 49.5 percent. But the gulf between the best and worst performing funds in the “sub-10” category was wide.
Birla Sunlife International Equity, contained its decline to 32 per cent, but the worst performer – JM Emerging Leaders – suffered a near-79 per cent erosion in its unit price.
The most-affected funds were theme or sector specific funds and tax-planning funds. Infrastructure and energy were key themes that witnessed a free fall this year.
New funds flagged off in the last 12-18 months saw their unit prices trimmed by 50-65 per cent.
Tax-planning funds too were prominent losers, thanks to several of them being biased towards mid-cap stocks. Even “contra” funds did not manage to buck the trend and lost between 42-70 percent.
One key lesson for the investor from 2008 is that if you are invested in theme funds, it may be best to quit when you are ahead.
If you can’t take an active approach, best to stick with plain vanilla diversified funds. Plus, a fund with a low NAV may be as risky as one with a higher NAV.
So before you rush to buy a fund at a “low” net asset value, evaluate it as you would evaluate one with a “high” NAV.
Friday, December 19, 2008
Debt funds fancied as bank rates head for slide
Debt funds schemes offered by mutual funds could turn out to be the investors' favourite as deposit rates of banks are set to fall in the coming weeks. Within debt funds, bonds that carry sovereign guarantee of the government such as the Reserve Bank of India bonds and infrastructure bonds, score over other such schemes, including income funds that largely invest in bonds issued by private corporations.
"Government securities ( G-Sec) is best placed for medium to long-term considering safety and view on interest rate," said Amar Pandit, a Mumbai based financial planner. Over the past one-year the G-Secs, also referred to as gilt funds, have generated an average return of 19 per cent while the income funds have generated 10.8 per cent.
Income funds invest mostly in corporate bonds. As banks reduce deposit rates, the returns on corporate bond also follow a similar pattern. "G-sec yields have come down from 9.5 per cent to 6 per cent over the past six months and it is expected to go down further in the view of global volatility," said Nilesh Shah, deputy managing director, ICICI (ICICIBANK.NS) Prudential AMC.
Experts said investors should check the portfolio before investing. "The only concern is on the credibility front and it should be above AA rated bonds," said Surya Bhatia, delhi based financial planner. The debt funds when invested for over a year get the indexation benefit and are liable for tax at the rate of 10 per cent and there is no exit load.
"Government securities ( G-Sec) is best placed for medium to long-term considering safety and view on interest rate," said Amar Pandit, a Mumbai based financial planner. Over the past one-year the G-Secs, also referred to as gilt funds, have generated an average return of 19 per cent while the income funds have generated 10.8 per cent.
Income funds invest mostly in corporate bonds. As banks reduce deposit rates, the returns on corporate bond also follow a similar pattern. "G-sec yields have come down from 9.5 per cent to 6 per cent over the past six months and it is expected to go down further in the view of global volatility," said Nilesh Shah, deputy managing director, ICICI (ICICIBANK.NS) Prudential AMC.
Experts said investors should check the portfolio before investing. "The only concern is on the credibility front and it should be above AA rated bonds," said Surya Bhatia, delhi based financial planner. The debt funds when invested for over a year get the indexation benefit and are liable for tax at the rate of 10 per cent and there is no exit load.
Debt funds offer higher returns in November
The debt funds have been under Sebi s lens in the recent past. But, interestingly, they have offered the highest returns to the investors in November, 2008. The monthly returns of the gilt funds were the highest at 3.07% followed by the long-term bond funds and liquid funds. However, the returns from the equity funds were negative due to the meltdown in the equity market, Crisil research report on MF industry for November found. According to Crisil s monthly review on the mutual fund industry, the open-ended income funds and liquid funds were the key beneficiaries with the former seeing net inflows of almost Rs 190 billion while the close ended income schemes (fixed maturity plans) saw a net outflows of a similar number. The AUMs of liquid funds increased by Rs 175 billion, a growth of 25 per cent over the October-end. The decline in the equity AUM of around Rs 70 billion was largely on account of mark-to-market losses. The share of debt funds AUMs in the domestic mutual fund continued to rise in 2008 from 61 per cent in January, 2008 to 71 per cent in November, 2008. Of the 35 mutual fund houses analysed, only two saw a growth in average AUM in November 2008. Tata MF registered 3 per cent and UTI MF witnessed a marginal growth in its AUM in November. With regard to the regulatory initiatives, Crisil report said that RBI has taken several initiatives to enhance the liquidity into the system. Sebi has sealed an early exit route in the closed ended mutual fund schemes and made it mandatory for the close ended schemes to be listed at the bourses. Sebi also decided that for such close ended schemes, the underlying assets will not have a maturity beyond the scheme s expiry , the Crisil report said
Individuals' share in asset value of MFs down 5 pcBy
The share of individuals in the total net asset value of all mutual funds declined to 37 per cent at end-March 2008 from 42 per cent in the previous year, while that of corporates, institutions and others rose to 57 per cent from 50 per cent for the same period, according to the annual report on the trends and progress of banking in India, 2007-08. Explaining the significant change, Prasunjit Mukherjee, a Kolkata-based mutual fund analyst, said, Fixed maturity plans (FMPs) as a category came in the fund industry some time in January 2008. They have a double indexation facility and the entire corporate base invested in FMPs of relatively longer duration. Individual investors invest mostly in equity-oriented funds and some portion in debt funds. Funds mobilised by mutual funds net of redemptions during 2007-08 rose sharply by 63.6 per cent to Rs 1,53,801 crore and the net assets under management of the mutual fund industry increased by 54.8 per cent during 2007-08. This significant increase in net mobilisation of resources by mutual funds was partly due to tax arbitrage. The interest from bank deposits is taxed at the marginal rate of taxation. The equity oriented mutual fund schemes are exempt from long-term capital gains, while short-term capital gains are taxed at 15 per cent. Dividend distribution from the money market and liquid funds is subject to 25 per cent tax plus surcharge and for schemes other than money market and liquid schemes; dividend distribution tax is 12.5 per cent plus surcharge. In the wake of the tight liquidity conditions since June 2008, mutual funds have faced redemption pressures. Mutual fund schemes also witness large outflows during advance tax payments. Fund facts • Share of individuals dropped to 37% at end-March 2008 while that of corporates, institutions and others rose to 57 per cent from 50 per cent • Individual investors invest mostly in equity-oriented funds and some portion in debt funds • Funds mobilised by mutual funds net of redemptions during 2007-08 rose sharply by 63.6 per cent to Rs 1,53,801 crore • The net assets under management of the mutual fund industry increased by 54.8 per cent during 2007-08
Tuesday, December 16, 2008
Jargon Buster
Jargon Busters
Average Portfolio Maturity and Duration
Bond and gilt funds are coming back into vogue – after a long dry spell of over 4 years. There was a time in the early part of this decade, when advisors sold only debt funds and concepts like average portfolio maturity and duration were closely tracked and hotly debated. What is duration and how is it different from average portfolio maturity? Why is duration a key parameter in deciding which fund is likely to perform better in a falling interest rate environment?
Generally, when interest rates fall, bond prices rise. A bond that has many more years to go before repayment of principal generally rises more that a short term bond, when interest rates fall.
A very basic example can illustrate why. Lets say you bought a 1 year Government security at par for Rs. 100 which pays out 10% interest at the end of the term. You now expect a cash inflow of Rs. 110 at the end of the term. Now, due to a change in market conditions, interest rates fall dramatically and the Government is now issuing 1 year paper at a 6% interest rate. If you were to sell your bond in the market, the buyer would expect a yield of 6%. The buyer will be willing to pay around Rs. 103 for your bond – as that is the price at which his yield would be approximately 6% - which is what he will get in the market today.
If on the other hand you had bought a 5 year zero-coupon bond from the Government which pays 10% interest (cumulative), you were expecting to get Rs. 161 from the Government at the end of your 5 year holding period. Now, the same situation happens and interest rates collapse to 6%. A buyer for this bond will now be willing to pay you around Rs. 120 for this bond – because that’s the price at which the yield works out to 6% - the current market yield.
As we can see, for the same rate of fall in interest rates (a simplistic case, no doubt), a longer dated bond’s price rises much more than a shorter dated bond’s price. But, as we will see below, it is not the tenure of the bond that matters – it is the maturity and duration that matter in determining its price.
Average Portfolio Maturity (APM)
If you bought a 5 year bond in the market 3 years after it was originally issued, there will be only 2 years left for the bond to mature. That is the maturity of the bond – and the maturity is far more relevant for a buyer because his cash flows will accrue over the next 2 years.
If you have a portfolio of bonds, each with its own maturity period, you will then calculate an average portfolio maturity (typically weighted by the individual amounts invested in each bond) to arrive at the APM of the portfolio.
A portfolio with a higher APM should normally rise more as a reaction to a reduction in interest rates, as compared to a portfolio with a lower APM. We saw in the simplistic example above, why this happens. That’s one reason why APM of a bond fund is closely tracked in a declining interest rate environment.
Duration
A higher APM is usually a good sign in a declining interest rate environment. But, is there a way one can estimate how much a fund’s NAV could rise for every 1% fall in interest rates? If you could estimate that, you will be able to decide which bond fund is best positioned to rally on a cut in interest rates.
This is where the concept of duration comes into play. Duration is calculated as the weighted average number of years to receive each cash flow in a bond. If a bond pays out interest every six months and is redeemed in say 4 equal annual instalments from years 7 to 10, it will have a smaller duration to a bond that is redeemed in a lumpsum at the end of 10 years, even if the interest is paid out semi-annually in the second bond as well. Why is this relevant to us? Because, duration of a financial asset measures the sensitivity of the asset’s price to interest rate movements. Therefore, duration of a bond fund portfolio can give you a good approximate of how much the NAV can appreciate for every 1% reduction in interest rates.
If a bond fund’s average duration is 4 years, and you expect a 2% reduction in interest rates, you can reasonably expect the NAV to appreciate by 4 times 2 --> 8% to reflect the 2% reduction in interest rates.
When you see fund fact sheets of bond and gilt funds, you will see both terms expressed : average portfolio maturity and duration. You will observe that duration is often far less than the APM expressed. That’s because each bond has different profiles of cash flows over the life of its residual maturity : all of which are captured in the term called duration.
Now, if you find two portfolios with identical APMs but the second has a higher duration and you expect interest rates to decline, which fund will you choose?
Average Portfolio Maturity and Duration
Bond and gilt funds are coming back into vogue – after a long dry spell of over 4 years. There was a time in the early part of this decade, when advisors sold only debt funds and concepts like average portfolio maturity and duration were closely tracked and hotly debated. What is duration and how is it different from average portfolio maturity? Why is duration a key parameter in deciding which fund is likely to perform better in a falling interest rate environment?
Generally, when interest rates fall, bond prices rise. A bond that has many more years to go before repayment of principal generally rises more that a short term bond, when interest rates fall.
A very basic example can illustrate why. Lets say you bought a 1 year Government security at par for Rs. 100 which pays out 10% interest at the end of the term. You now expect a cash inflow of Rs. 110 at the end of the term. Now, due to a change in market conditions, interest rates fall dramatically and the Government is now issuing 1 year paper at a 6% interest rate. If you were to sell your bond in the market, the buyer would expect a yield of 6%. The buyer will be willing to pay around Rs. 103 for your bond – as that is the price at which his yield would be approximately 6% - which is what he will get in the market today.
If on the other hand you had bought a 5 year zero-coupon bond from the Government which pays 10% interest (cumulative), you were expecting to get Rs. 161 from the Government at the end of your 5 year holding period. Now, the same situation happens and interest rates collapse to 6%. A buyer for this bond will now be willing to pay you around Rs. 120 for this bond – because that’s the price at which the yield works out to 6% - the current market yield.
As we can see, for the same rate of fall in interest rates (a simplistic case, no doubt), a longer dated bond’s price rises much more than a shorter dated bond’s price. But, as we will see below, it is not the tenure of the bond that matters – it is the maturity and duration that matter in determining its price.
Average Portfolio Maturity (APM)
If you bought a 5 year bond in the market 3 years after it was originally issued, there will be only 2 years left for the bond to mature. That is the maturity of the bond – and the maturity is far more relevant for a buyer because his cash flows will accrue over the next 2 years.
If you have a portfolio of bonds, each with its own maturity period, you will then calculate an average portfolio maturity (typically weighted by the individual amounts invested in each bond) to arrive at the APM of the portfolio.
A portfolio with a higher APM should normally rise more as a reaction to a reduction in interest rates, as compared to a portfolio with a lower APM. We saw in the simplistic example above, why this happens. That’s one reason why APM of a bond fund is closely tracked in a declining interest rate environment.
Duration
A higher APM is usually a good sign in a declining interest rate environment. But, is there a way one can estimate how much a fund’s NAV could rise for every 1% fall in interest rates? If you could estimate that, you will be able to decide which bond fund is best positioned to rally on a cut in interest rates.
This is where the concept of duration comes into play. Duration is calculated as the weighted average number of years to receive each cash flow in a bond. If a bond pays out interest every six months and is redeemed in say 4 equal annual instalments from years 7 to 10, it will have a smaller duration to a bond that is redeemed in a lumpsum at the end of 10 years, even if the interest is paid out semi-annually in the second bond as well. Why is this relevant to us? Because, duration of a financial asset measures the sensitivity of the asset’s price to interest rate movements. Therefore, duration of a bond fund portfolio can give you a good approximate of how much the NAV can appreciate for every 1% reduction in interest rates.
If a bond fund’s average duration is 4 years, and you expect a 2% reduction in interest rates, you can reasonably expect the NAV to appreciate by 4 times 2 --> 8% to reflect the 2% reduction in interest rates.
When you see fund fact sheets of bond and gilt funds, you will see both terms expressed : average portfolio maturity and duration. You will observe that duration is often far less than the APM expressed. That’s because each bond has different profiles of cash flows over the life of its residual maturity : all of which are captured in the term called duration.
Now, if you find two portfolios with identical APMs but the second has a higher duration and you expect interest rates to decline, which fund will you choose?
Thursday, December 4, 2008
Insurnace Merger & Acquisition
New Delhi, Dec. 3 The Insurance Regulatory and Development Authority (IRDA) is pitching for consolidation in the Indian insurance industry. The IRDA Chairman, Mr J. Hari Narayan, said today that the regulatory authority was working on guidelines for mergers and acquisitions (M&As) in the insurance sector.“There is a need to evolve M&A guidelines. Given what is happening across markets, it may be an opportune time for insurance industry to consider M&As. But in India we do not have within the insurance regulatory roadmap (framework) appropriate guidelines in this regard. I think we need to evolve some of them and we are working on them”, he told a FICCI conference on insurance here. A consolidation in the industry is expected to help improve competitiveness of the players besides providing increased benefits to customers. Since the opening up of the insurance sector, the number of participants in the industry has gone up from six insurers (including Life Insurance Corporation of India, four public sector general insurers and General Insurance Corporation, as the national re-insurer) in 2000 to 42 insurers operating in the life, non-life and re-insurance segments as of today. During 2008-09, registration had been granted to three companies in the life segment. At the conference, Mr Hari Narayan noted that insurance companies would be getting into an asset-liability mismatch of “varying degrees of intensity as we go along”. He highlighted that the lack of availability of long-term securities in the market might impact certain kinds of liabilities that would arise in the future. “This is one issue that we would be taking up with the Finance Finistry at an appropriate time”, Mr Hari Narayan said. The IRDA Chairman asked the insurance companies to use the opportunity of this downturn to get their house in order (improve treasury management performance etc) and build foundation for future growth, which he said would help double penetration of insurance in the country.He also raised the issue of variation in management expenses ratio among the life insurance companies that have been in operations for at least five years. On the issue of changes in solvency regime, Mr Hari Narayan felt that it was perhaps “premature” or may even be “imprudent” at this point of time to expect wide-ranging or significant changes in the solvency regime in the Indian insurance sector. Mr Hari Narayan also said that IRDA was looking at rationalising the insurance intermediary sector.
Monday, December 1, 2008
Analysi of Pharma Fund
Pharma Funds are sectoral fund predominantly investing in the pharma or related companies. These funds aim to provide the investors maximum growth opportunity through equity investment in stocks of Pharma sector. Pharma funds that were considered a contrarian bet, have also assumed an envious place amongst the equity fund categories by losing the least. The category average of pharma funds posted the negative returns of 29.42% underperforming the BSE Healthcare index, which lost around 25.50% over one year period ended 26 November 2008. However, Pharma funds have outperformed the broad market with the BSE Sensex losing 53.10% in this period.
During the same period all other sub categories under equity category registered more than 50% erosion in their category average in one year period.The pharma sector category recorded net asset of Rs 183.15 crore as on the 31 October 2008, 35% less than the net assets of Rs 286.05 crore as on 30 April 2008. Except Auto (net assets increased by 1.06%) and index fund ( a fall of 13%) category all other equity sub categories reported a fall in net assets higher than the pharma category. Equity diversified fund assets diminished by 45%.
UTI - Pharma & Healthcare Fund is an open-ended growth scheme investing in stocks of companies engaged in the research manufacture or marketing op Pharmaceuticals - bulk drugs, OTC products, medical equipment and accessories, personal healthcare products and also companies owning/managing hospitals. The fund is now continuing the asset worth of Rs 43.29 crore. It has highest exposure in sun pharma, Cipla and Glaxo.Franklin Pharma Fund is an open ended growth fund with the primary investment objective to achieve long term capital appreciation through exclusively investing in Pharmaceutical/Life sciences. The fund is now managing about Rs 35 crore and it has highest exposure in Lupin, Cadila Healthcare and Dr Reddys Laboratories.
During the same period all other sub categories under equity category registered more than 50% erosion in their category average in one year period.The pharma sector category recorded net asset of Rs 183.15 crore as on the 31 October 2008, 35% less than the net assets of Rs 286.05 crore as on 30 April 2008. Except Auto (net assets increased by 1.06%) and index fund ( a fall of 13%) category all other equity sub categories reported a fall in net assets higher than the pharma category. Equity diversified fund assets diminished by 45%.
UTI - Pharma & Healthcare Fund is an open-ended growth scheme investing in stocks of companies engaged in the research manufacture or marketing op Pharmaceuticals - bulk drugs, OTC products, medical equipment and accessories, personal healthcare products and also companies owning/managing hospitals. The fund is now continuing the asset worth of Rs 43.29 crore. It has highest exposure in sun pharma, Cipla and Glaxo.Franklin Pharma Fund is an open ended growth fund with the primary investment objective to achieve long term capital appreciation through exclusively investing in Pharmaceutical/Life sciences. The fund is now managing about Rs 35 crore and it has highest exposure in Lupin, Cadila Healthcare and Dr Reddys Laboratories.
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