- Mr Market
- 13-Feb-2013
Why does Prospero Tree recommend you to read this article?
Interim price fluctuation is one of the key differences between NCDs and bank fixed deposits. Current price of an NCD is an indicator of the effective returns that you can gain from an NCD. As an illustration, investment in Muthoot Finance NCD at different times could have yielded annual returns of 10.2%, 12.25% and 14.3%. This article aims at:-
- Understanding why the price fluctuation happens
- Understanding effective returns from NCD by investing at the current price
- Identifying times when returns can be disproportionately high
Why does the price of an NCD fluctuate?
Price of an NCD has an inverse relation to the interest rate changes in the economy i.e. it goes up if the interest rates cool down and vice versa. The reason for this is quiet intuitive if the current interest rate in the economy is 9%, nobody will sell me an NCD with coupon rate of 12.3% at the base price of Rs100. He would ask for a premium. In reality, the markets will adjust the price of such an NCD upwards so that the effective yield on the NCD is close to 9%.
Chart 1 - Inverse relation with interest rates
Concept of yield to maturity
This can best be illustrated by what happened to Muthoot Finances NCD from Aug-11 to Sep-12. The bond has a coupon rate of 12.25% and face value of Rs1000, implying that the investor get an interest of Rs112.5 every year. An investor purchased the NCD at Rs1000 in the public issue. If this investor were to hold the bond till maturity, he would earn an effective yield of 12.25% over the life of the bond.
Table 1- Returns based on timing of investments
Now the bonds were listed in Sep-11 at a substantial discount to its face value as interest rate outlook, as well as company specific outlook, looked bleak (although there was not even a whiff of a default). Suppose a new investor bought the bond after listing at Rs933. His cash-flows from the bond (Table 1) would ensure him a yield of 14.2% over the life of the bond. In the bond market terminology, yield means the effective returns one would earn from investing in a bond today. It is calculated using the discounted cash flow method.
Some more illustrations of price fluctuation in different interest rate regimes
A host NCD issue that got listed between Aug11 and Dec11 traded at a 'discount' i.e the traded price of the NCDs was lower than their face value. Key reasons were 1) Expectation that interest rates in the economy may further increase, and 2) Weak business outlook would result in higher cost of borrowings for these NBFCs.
Table 2 - Impact of price fluctuation on yields
So why did it make immense sense to invest in these NCDs? Investors who bought these NCDs in Oct-11 will earn high yields ranging from 14.2% to 10.6% over the lifetime of the NCD. The returns looked fabulous when compared to a five-year bank fix deposit that paid ~8.5%. The only potential risk was company business going so bad that it would be unable to re-pay its NCD investors. Our research team at breathing stocks tracked the company's business closely and was confident that such a possibility was very remote and we had advised our clients to buy them in Oct 2011. As an NCD investor, you get affected only if the company is on the verge of bankruptcy, not if the company is making lesser profits.
A lot has changed since then - the overall interest rates have cooled off and fears of permanent damage to its business have receded and the NCD traded at Rs982 in Nov-12.
Prospero Tree view
Yields are central to understanding the returns one can earn by investing NCDs at the current price. They can witness wild fluctuations within the life of an NCD and at times, offer very attractive investment opportunities. While calculating yields may be quite mathematical and un-interesting for individuals, we will periodically publish yields of NCDs that we believe are safe investments. We will also highlight good investment opportunities in the NCD space as and when they arise out of price fluctuations.