Download Tax Saving Mutual Fund Application Forms
Invest In Tax Saving Mutual Funds Online
Leave a missed Call on
94 8300 8300
| When you hear debt fund managers tell you about how they are going to make good money from an expected flattening of the curve, do you understand what they mean, what portfolio action they are going to take and what this might mean in terms of returns on income funds? Then, if they go on to tell you about how they are adopting a barbell strategy as opposed to a laddering strategy, do you really get what they are saying or do you find yourself nodding politely in complete bewilderment? If this kind of jargon leaves you perplexed and confused, read on as we try to explain all that you need to know as an advisor about yield curves and their implications on income fund returns..... |
| Yield Bonds are usually recognized by yields. Simply speaking, yield is the rate of return an investor receives on the maturity of his bond. For a bond, yield is a function of the coupon (or interest) payments which are fixed and the bond's purchase price. There exists an inverse relationship between the bond price and interest rates. Bond prices are correlated with their yields. As market interest rates decrease, bond price will increase on account of higher relative coupon rate the bond produces thus becoming more attractive to the investors. Yield can be measured in two ways: Current Yield and Yield to Maturity. Current yield is simply the coupon interest received with respect to the current market price of the bond. Yield to maturity is a more acceptable measure of calculating the rate of return on a bond. It can be defined as the discount rate at which the present value of cash flows (in terms of coupon payments and the face value of the bond) equals to the current market price of the bond. When we talk about yield curve, our concern is yield to maturity and not current yield as the former is a better indicator of the rate of return on a bond. Yield Curve Yield curve establishes the relationship between yield to maturity and number of years to maturity for bonds having same credit quality. For instance, from the plot below, we can make out that a 2 year Treasury bond is having a yield of 3.5, a 10 year Treasury bond is having a yield of 4 and a 12 year bond is having a yield of 6%. Treasuries are issued by the central government of a country and are considered risk free. The yields of treasuries are used as benchmarks for pricing other fixed income instruments. The yield curve clearly illustrates the spread of yields that arises due to difference in the maturities of the bonds of same asset class.
Shapes of Yield curve Three types of yield curve have been observed historically. These are: 1. Normal or upward sloping yield curve: Here, the investor earns higher yields for holding longer maturity bonds. It is a normal expectation of a market to expect higher yields for holding securities for longer periods due to the risks associated with it. The slope of a yield curve is a good indicator of the economic activity. The yield curve also reflects the investors view about the future interest rates. An upward sloping or steep yield curve indicates an economic upsurge. This states that the economic growth will bring in high inflation which would lead the central banks to increase the interest rates to control the inflation. This will affect the bond returns. Hence, higher inflation and interest rates lead the investors to demand higher yields at longer maturities. As we know, when interest rates increase, bond prices will decrease and yields will rise. In a scenario of normal yield curve, investors should be recommended to invest in longer maturity bonds if they desire higher yields. YTM
2. Flat yield curve: Here, the yield does not vary much with the maturities and remains constant. This may be due to the ambiguous signals and expectations of the market. This may indicate a transitionary period to economic expansion or contraction. A flat curve indicates slowdown of economy. This usually happens when central banks try to contain inflation by increasing interest rates, thus increasing short term yields. However, with the actions taken, the expectations of high inflation begin to subside to moderate inflation and expectations of higher long term rates also fall. In such a scenario, investors can be advised to invest in bonds with lower maturities, as they are not being adequately compensated by way of higher yields for the risk of investing in longer dated securities. YTM
3. Inverted or downward sloping yield curve: Here, long maturities entail lower yields. This usually indicates economic contraction. Interest rate decline is expected in the future. As interest rates decline, bond prices will move higher and yields will decrease. This may be the result of central banks loosening the monetary policy to revive the economy. Lower interest rates would lower the inflation expectations. Hence, here short term yields are higher than the longer term yields. Though short term yields are greater, few investors may still seek long term bonds as they expect a further economic slowdown where interest rates will further decline resulting in still lower yields. Yield curve shift The relative change in the yield for each bond maturity is called the shift in yield curve. If the change in yield of all maturities is same, it is a parallel shift, while non equal changes in yield of all maturities bring about a non parallel shift in the yield curve. When there is a change in the shape of the yield curve, it implies that one needs to change his outlook on the economy. When the slope of the yield curve decreases, it is known as flattening of the yield curve and when the slope of the yield curve increases, it is known as the steepening of the yield curve. We can say that when the yield curve flattens, the yields for longer term maturities decline. When yields decline, that means bond prices go up. If bond prices go up, income funds which hold these bonds will see their NAVs appreciate to that extent. This implies that if a fund manager is expecting the yield curve to flatten at the longer end of the curve, he must hold substantial positions in long term bonds to take advantage of an expected rise in bond prices, which can give attractive capital gains to his investors as the NAV rises to account for higher bond prices. Over time, the overall yield on this portfolio will decline to factor in the prevailing lower yields in the market. But, before that sets in, there are some gains to be had by positioning oneself for an expected flattening of the curve. Conversely, when the yield curve steepens, the yields for longer term maturities rise. If yields rise, that means bond prices are falling. If bond prices are falling, the NAVs of income funds that own these bonds will be negatively impacted - will drop to the extent of the fall in bond prices. If the fund manager is anticipating a steepening of the yield curve, he would shift from long term maturity papers to short term maturity papers, to minimise the negative impact on the prices of bonds he owns and therefore on the NAV of the fund. Over time, however, the longer dated papers will yield more and therefore, the fund manager would like to move back into long dated papers, once the steepening has taken place. This will ensure that the "accruals" in the fund - the interest income arising from the bonds he holds is maximised by investing in long dated papers that now fetch a much higher interest as the yield curve has steepened. Changes in the level of rates, in the slope of the yield curve and the changes in the curvature of the yield curve affect the bond returns and therefore the returns of income funds. Income fund managers seek to dynamically manage their portfolio maturities to either take advantage of expected favourable movements in the yield curve or to shield themselves from expected unfavourable movements in the yield curve. Managing this interest rate risk is one of the key functions of an income fund manager. The duration measure can be used for quantification of this risk. Yield curve strategies Fund managers can earn above average returns by taking advantage of forecasted movements of the yield curve based on distribution of maturities. When yield curve changes its level as well as shape, it can have a huge impact on the portfolio returns. Some of these strategies are:
Lets take an example: An investor wants to invest INR 1000000 in a bond portfolio. He wants low reinvestment risk and does not want his portfolio to be concentrated in a single maturity range. In such a scenario, the investor would be advised to invest equal INR amounts at even intervals along the yield curve. We assume that he buys 10 bonds with face value of INR 100000, maturing annually for ten successive years. After the first bond matures, he reinvests the proceeds in another ten year bond and the cycle continues. Though bond laddering leads to diversification and lessens the risk of fluctuating interest rates, it is a passive management strategy and the fund managers would not be able to produce an alpha return due to the changing characteristics of the yield curve. This strategy should be used when investor primarily desires risk diversification. Yield curve helps the fund managers to take a view about the impending economic activity. Active bond management depends on an economic scenario in order to forecast the movements of yield curve. Also, yield curve can be used as a reference to price other fixed income instruments such as corporate bonds. Fund managers can undertake valuation analysis of bonds using the yield curve. Applying different interest rate forecasts, they can value the bond using the discount rate or yield and can arrive at a decision whether the bond appears cheap or expensive. They can thus advise the investors to earn above average returns by buying cheap bonds and selling the expensive ones. Yield curves can prove to be instrumental for the fund managers. They can create their bond portfolios by forecasting the interest rate movements and the economic activity. Also, by using different yields at different points of the yield curve as the discount rate, fund managers can arrive at fair valuations of the bond price and invest suitably. | ||
For further information contact Prajna Capital on 94 8300 8300 by leaving a missed call
Leave a missed Call on 94 8300 8300
Leave your comment with mail ID and we will answer them
OR
You can write back to us at
PrajnaCapital [at] Gmail [dot] Com
---------------------------------------------
Invest Mutual Funds Online
Download Mutual Fund Application Forms from all AMCs
Download Mutual Any Fund Application Forms
---------------------------------------------
Best Performing Mutual Funds
- Largecap Funds Invest Online
- DSP BlackRock Top 100 Fund
- ICICI Prudential Focused Blue Chip Fund
- Franklin India Bluechip
- ICICI Prudential Top 100 Fund
B. Large and Midcap Funds Invest Online
- ICICI Prudential Dynamic Plan
- HDFC Top 200 Fund
- UTI Dividend Yield Fund
- Birla Sun Life Front Line Equity Fund
- Franklin India Prima
C. Mid and SmallCap Funds Invest Online
- Reliance Equity Opportunities Fund
- DSP BlackRock Small & Midcap Fund
- Sundaram Select Midcap
- IDFC Premier Equity Fund
- Birla Sun Life Dividend Yield Plus
- SBI Emerging Businesses Fund
- HDFC Mid-Cap Opportunities Fund
- ICICI Prudential Discovery Fund
D. Small and MicroCap Funds Invest Online
- DSP BlackRock MicroCap Fund
2. Franklin India Smaller Companies
E. Sector Funds Invest Online
- Reliance Banking Fund
- Reliance Banking Fund
- ICICI Prudential Banking and Financial Services Fund
F. Tax Saver Mutual Funds Invest Online
1. ICICI Prudential Tax Plan
2. HDFC Taxsaver
- DSP BlackRock Tax Saver Fund
- Reliance Tax Saver (ELSS) Fund
G. Gold Mutual Funds Invest Online
- Relaince Gold Savings Fund
- ICICI Prudential Regular Gold Savings Fund
- HDFC Gold Fund
- Birla Sun Life Gold
H. International funds Invest Online
1. Birla Sun Life International Equity Plan A
2. DSP BlackRock US Flexible Equity
3. FT India Feeder Franklin US Opportunities
4. ICICI Prudential US Bluechip Equity
5. Motilal Oswal MOSt Shares NASDAQ-100 ETF
0 comments:
Post a Comment