We learnt about the concepts of fixed income in the first tutorial by taking an example of a simple fixed deposit. You placed a principle of Rs 100 in a three year maturity fixed deposit with SBI (State Bank of India). You received 8.5% per year for three years as interest on your fixed deposit. You got back your money from SBI at the end of three years. The investment in fixed deposit could be equated to a bond with a face value of Rs 100 paying a coupon of 8.5% per annum and maturing at the end of three years. The difference between the fixed deposit and the bond is the value of the bond when interest rates change.
Interest rate change and its effect on fixed deposits
A principle of Rs 100 invested in SBI for three years at 8.5% interest rate will generate Rs 8.5 every year for three years. At the end of the third year you get back your principle of Rs 100. The principle remains static throughout the three years and neither depreciates nor appreciates in value even if interest rates change during the deposit period. For example, after placing the deposit at 8.5% for three years, you go next year to SBI for a three year deposit. SBI offers you 9.5% interest rate for a three year deposit. The higher interest rate offered implies that interest rates have gone up in the market. The fact that interest rates have risen does not affect the principle value of your fixed deposit investment though you have lost the opportunity to invest at higher rates.
Interest rate change and its effect on bonds
Investment in a bond with similar terms as a fixed deposit exposes you to interest rate risk. You are holding one SBI bond of face value Rs 100 with an annual coupon rate of 8.5% and having a maturity of three years and interest rates rise. The price of the bond will increase or decrease depending on the movement in interest rates. For example if you want to sell the bond next year to place the money in a three year fixed deposit paying 9.5% interest, you will get back only Rs 98/- which is the price of the bond at the time of selling the bond. The price of the bond has decreased due to rise in interest rates. The face value of the bond remains same at Rs 100 but the value of the bond is lower due to rise in interest rates.
The price of the bond moves up when interest rates fall. If the interest rate on the fixed deposit falls to 7.5% after one year, the price of the bond will then become Rs 102. You have gained Rs 2 on the face value of the bond due to the fall in interest rates. The value of the fixed deposit does not change.
The reason why the price of the bond rises or falls with a rise or fall in interest rates is due to the time value of money. The bond is valued using a discounted cash flow (DCF) method, of which we will talk about in the next tutorial.
The concepts you have learned here is that if interest rates rise or fall your fixed deposit value remains the same while your bond value changes as per the rate of increase or decrease in interest rates.