Hi guys,
Since @Atharva raised the point of duration and liquidity so I would love to explain this.
I will be simplifying things but please note bond market is dynamic and all the explanation below is just to give a basic understanding.
Before starting we will assume the inflation should be equal to coupon rate for bond to trade at par and bonds price exabit linear relationship with change in inflation.
Eg: If inflation goes up by 10bps bond price will fall by 1rs per 100, so a 20bps hike will be 2rs fall per hundred (LINEAR MOVEMENT).
In my above post what I was referring to YTM is called simple yield. Simple yield does not account for compounding and coupon reinvestment.
YTM is the discount rate at which the NPV of coupon payment and principle repayment will be 0. It is same as IRR.
Eg. 10yrs maturity,6% coupon, annual payment and CMP of 90 will give us a simple yeild of 7.77% but YTM of 7.45%.
This YTM means that if inflation stays stable you will make a 7.45% CAGR on your investment(assuming you reinvest your interest)
when interest rates go up you reinvest you coupon at a higher rate but you suffer a notional loss on your bond value.(Bond price go down when interest rates go up)
So the capital loss > than the benefit of bond reinvestement at higher rates. Hence you YTM fall when rates go up.
When interest rates go down you reinvest your coupon at a lower rate but you have a notional profit. So you capital gain here is > than reinvestment loss. hence YTM goes up
Now what if I say after a specific year the reinvestment risk is > than capital loss/profit.
After a certain year if interest rates go up your reinvestment profit > than capital loss(vice versa). Hence YTM increases despite interest rate hike.
This entire concept is known as macaulay duration. Eg: if your macaulay duration is 5yrs this means before 5yrs capital gain/loss is dominent and after 5yrs reinvestment is dominent.
The second concept is modified duration. This measures the %change in bond price per 100bps change in YTM.
Why I explained all this?
Suppose you bought a 90rs bond,6% coupon,10yrs maturity, annual payment, YTM of 7.45% with macaulay duration of 5 and modified duration of 4.65.
Now if you are expecting inflation to fall by 100bps you know your bond will appreciate by 4.65% and you also know this has to happen before 5yrs because after that you eventually start loosing money despite capital appreciation.
When I made this post inflation was at 8yrs high. This means Once in 8yrs opportunity. Inflation as per me was bound to go below 6% in 2yrs. So eventually you end up making 11% to 12% kind of return. So instead of FD this was a way way attractive opportunity.
Your compute your returns after adjusting for the risk you take ,but in this case government bonds is risk free so theoretically 11% to 12% is you risk adjusted return.
Now bondholder’s have a prior claim than shareholder. We can also invest in corporate bonds of PSU which are trading at a YTM of 10% to 12%. With capital gain you can make more than this but here you have LIQUIDITY RISK which is not the case with GOI bonds. So If you can do some research and find good active corporate bonds you can make decent returns.
Bond is very dynamic and it is not so simple as I explainded. Instutions purchase extremely expencive softwares for trading in bonds becasue they benfit for it. For retailers it does not make sensec to purchase those software hence their participation is low.
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