Bond Basics - Apperceive Your Funds Features and Risks
Bonds provide an stupendous medium of diversification. They could, on occasion comport as even more lucrative investments than equities provided one has accoutered the know-how of when to invest, i.e. Investing when the interests rates are postulated to fall in the future, and pulling out when the scenario is reversed.
The risks that are confederated with investing in bonds are several, the primary being the interest rate risk. Other risks are the risk from the change in the shape of the yield curve, credit risk, liquidity risk, inflation risks (which tend to diminish the real returns from one's investment), Volatility risks etc.
The prices of debt engage in an inverse relationship to the interest rates, and the 'Interest Rate Risk' is typically the risk of change in the price of a bond in response to the change in interest rates. This measure is commonly referred to as 'Duration'.
Duration = Change in bond price (%) / Change in yield (%)
Duration is naturally greater with bonds of longer maturity, and bonds with lower coupons and vice versa.
The 'Yield Curve' is the graphical representation of the relationship between maturity and the yields. This curve will be upward sloping when the interest rates are expected to rise in the future and downward sloping when they are expected to fall. Changes in the shape of the yield curve captures the interest rate risk not measured by duration and is known as 'Yield Curve Risk'.
Current Yield = Annual Coupon Payments / Price of a bond
Yield to maturity is the internal rate of return based on a bonds price and coupon and maturity payments (Cash Flows)
Many investors however are incapacitated with how to go about investing, which is why it is wise to buy into a portfolio of bonds through a debt mutual fund. Funds generally use the terms Effective Duration and Modified Duration.
Effective Duration = (Price when yields fall- Price when yields rise) / 2 * (Initial Price) * (Change in yield)
A portfolio's effective duration is the weighted average duration of individual securities in a portfolio.
Modified Duration = Macaulay Duration / 1 + YTM
Macaulay Duration is expressed in years and measures the interest rate sensitivity till the bonds cash flows arrive.
While choosing the fund of your choice, bear in mind that in a scenario of rising interest rates, avoid a traditional longer maturity debt fund, and opt for floating rate instruments, that reset their coupon payments depending upon the prevailing interest rates and liquid funds consisting of papers with short maturities and T-Bills.