“Kabhi Kabhi 8% interest rate 20% profit se zyada acha hain” !!!

I don’t believe in the theory and academic knowledge. I believe in practical knowledge

After reading this article, you will wait for the next series.

All theories will be explained practically in this article

Hello readers and investors. Welcome to Being Inkspired. In this series “Bond Prices and Interest Rates” we will cover the bond price and interest rate dynamics

However, for understanding the broader relationship between bond prices and interest rates, we need to know the basics of bond markets and how bond prices are determined.

In the first part of this entire series, we are going to learn the practical application of the “time value of money” and its application in bond pricing.

We will also learn different measures of yield that are very important for analyzing a bond’s performance.

So, the basic things that we are going to cover in the first part of the series include

Time Value of Money
Nominal and Real rates of return
Risk Premium
Future value (FV)
Present Value
Difference between Sovereign and Government bonds

In the second part of the series, we will be covering

Bond Pricing - Bond Prices definition, corporate bond prices
Bond Yields - Bond Yield formula, current bond yields, corporate bond yields by credit rating, government bond yields explained, sovereign bonds yield and yield-to-maturity

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Also read - Farm Bill 2020 - Another blow for democratic India.

Bond Prices and Interest Rates - Time Value of Money - Money is not equal to God but it is also not less than God

The time value of money is based on the basic assumption that people have a positive time preference for consumption. It simply means that people want to consume today rather than in the future.

Therefore, we can say that a dollar received today is worth more than a dollar received in the future.

This is practical since if you earn a dollar today, then you can invest the money and earn interest on the investment.

There is also another way in which we can explain the above fact

A dollar received today will have less purchasing power in the future. Therefore, what you can buy today with one dollar, you can’t buy the same quantity of that commodity with that one dollar in the future.

Therefore, we can say that money loses its value if kept idle because of the increase in the inflation rate.

So, an intelligent investor will invest money in an asset where he will get a return more than the rate of inflation. If the rate of return is less than the inflation rate, then his investment will yield negative real returns.

Therefore, we can say

Real Return on Investment = Nominal Returns - Inflation Rate ------- (1)

What is the nominal rate of return -

Suppose Mr. Rahul invests $40000 in a fixed deposit for 3 months which gives him a guaranteed return of 5%. Therefore, the bank is giving a 5% return on Rahul’s $40000 investment. This 5% return that Mr. Rahul is getting from the bank is known as the nominal rate of return.

What is the real rate of return?

Now, let’s say that the inflation rate is 7% in this 3 month period. So, although Mr. Rahul is getting a return of 5% from the money he invested in the bank, he is actually losing 2% in the real sense as prices have gone up by 7% in this period. This loss of 2% is actually known as the Real rate of return or real interest rate

What is the risk premium? - No-Risk No Money

So, in our example, Mr. Rahul is an intelligent investor and a notorious businessman. He will not invest his money in fixed deposits.

Suppose he wants a real return of 10% on his investment. This means that he has to invest his money in an asset which gives a nominal return of 17% since prices will increase by 7%.
So, Mr. Rahul will invest money in that security which will give him a 17% nominal return. Believe me, no bank will give a nominal return of 17% to Mr. Rahul. Fixed deposits although have low returns but are guaranteed.

Bonds also gives a maximum nominal return of 10%. So, Mr. Rahul has to invest the money in riskier assets like stocks, commodities, mutual funds, and future and options securities.
So, let’s say Mr. Rahul invests the money in a corporate bond which gives him a 17% return. Corporate bond yields are higher but it carries more risk than Treasury bond yields or bonds yield.

So, Mr. Rahul is taking more risk by investing in the corporate bonds and therefore he demands compensation for taking the extra amount of risk. Therefore, the corporate bond issuer will provide extra compensation to Mr. Rahul for taking this risk.
This extra amount of compensation which Mr. Rahul gets for taking the additional risk is known as the risk premium

So, less risky assets yield less nominal returns while high-risk assets yield higher returns.

Future Value and Present Value - Power of Compounding or the “Compounding Effect”

Theory

Future Value (FV) is the value of a given amount of money invested today at a given point in the future.

Future Value (FV) or the compounding value is calculated by

FV = PV(1 + i)^n

FV = Future value of an investment n periods in the future

PV = Present value of an amount of money today - The amount of money that you are investing today

i = nominal interest rate

n = number of compounding periods

Did you understand anything? -

Practical - Returning to Mr. Rahul

Suppose Mr. Rahul invests $100 in a fixed deposit for 5 months which gives him a guaranteed return of 4% compounded annually.

Applying the above equation, we can calculate the FV

PV = 100

i = 4%

n = 5 (Since interest is getting compounded annually. He is keeping the money for 5 years and therefore the money will be compounded 5 times)

So, FV = $121.67

So, we can say that the FV of $100 invested in a bank for 5 years, providing an interest rate of 4% compounded annually is $121.67.

Now, what happens if the bank decides to pay interest rates on a quarterly basis which implies that the number of the compounding period each year is now equal to 4.

Rahul’s money is getting compounded 4 times every year

Therefore, n = (5 years into 4 quarters) = 20

The FV now becomes equal to $122.02

So, what did you find out from this practical example?

Return on Investment (ROI) increases with an increase in the number of compounding periods. The higher the number of compounding periods, the higher will be your ROI

This simple thing is known as the “Compounding Effect” or the “Power of Compounding”

Congratulations, you have understood the logic behind “value investing”.

So, what the hell is Present Value (PV) or the process of discounting.

Present Value is simply the opposite. In pour example, $122.02 was the FV of $100. So, just reverse the definition.

Therefore, $122.02 received after 5 years is worth $100 today. So, PV of $122.02 is $100. This is known as the process of discounting.

Bond Prices and Interest Rates - Difference between Sovereign and Government bonds

Government bonds are securities or financial obligations issued by a central government or a state government (these are also called sovereign bonds). Governments use these loans to fund new initiatives or infrastructure, while for investors, they are a source of returns.

There is no difference between Government bonds and sovereign bonds. Both are issued by any form of government.

These are also known as government securities or G-secs

However, there is a difference between treasury bills and G-secs.

Treasury bills are generally short term bonds with a maturity period of fewer than 180 days. Treasury bills are generally “zero-coupon bonds”. We will explain all these details in the next article.

What are Zero-coupon bonds?

Zero-coupon bonds are those types of bonds that don’t pay any coupon payments to bondholders.

You might be asking what are coupon payments or coupon rate

Well in bond markets, the rate of interest is known as the coupon rate and the amount of interest earned by the bondholder is known as the coupon payment

So, if we don’t receive any interest payment why we will invest in a zero-coupon bond.

The answer is simple. Zero-coupon bonds are available at a discount from its face value or par value but during the time of maturity we can sell it at its face value

Say Mr. Rahul buys a zero-coupon bond having a Face Value of Rs. 100 available at a 5% discount on its face value.

Therefore, smart Rahul will get the bond at Rs. 95. However, during the time of maturity, he will sell the bond at its face value of Rs. 100

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