Dipankar Jakharia
Uncle Jolly Singh, the retired Colonel of our housing society, was the star attraction of all our parties, until this New Year’s. Before any housing society dinner, you would find him in a hyper-active mode, with his khata and kalam taking care of the spirits, with his quota of supplies from the Narangi army canteen. When I asked Mrs. Singh the reason behind his sour mood, I came to know that his recent trip to the bank didn’t go too well.
“Tell me, Puttar, when the interest rates of our deposits are going down, how can interest from the bonds go up? I have no trust left on these bankers anymore,” said a disgusted retiree who heavily relies on the interest income from his deposits. But what the banker told him was 100 per cent correct. Although it seems somewhat impossible, the interest rate of bonds plays inversely to the interest rate of fix deposits. Therefore, when the interest rate of your FD is doing down, the interest that you earn from the bond is going up and vice-versa.
So, what is bond? Why is it different from other investing instruments? What are the advantages or disadvantages of it?
Let us learn about it:
A bond is an agreement between a borrower and a lender to return the money borrowed (by the borrower to the lender) within a limited time frame agreed upon. The borrower also agrees to pay a periodic interest until the return of the amount. Bonds are issued by both companies and governments across the globe and also in India.
Suppose, the Government of India is in need of money and decided to borrow it from the public, then the government will issue bonds to the public. Now to encourage lending, the government will promise to pay a periodical interest for any lender/ investor willing to lend his or her money. Normally, the government will promise an interest at par with the prevailing market rate of the time. Say, a bond of Rs. 100 will fetch an interest rate of eight per cent per annum for a period of ten years. So, the government will pay the lender/investor Rs. eight per year, as an interest for ten years and at the end of the tenth year, will return the principal amount of Rs. 100. Now this is plain and simple. There cannot be any ambiguity in it.
But the government or companies regularly issue bonds and there is a secondary market to trade your bonds, in case you need your money before the maturity. Suppose, you have purchased a ten-year government bond with an interest rate of eight per cent. The very next year, the interest rate goes down and government issues new bonds. Will it give the same high interest like the previous year? Certainly not. Say, that year, it gives an interest of seven per cent. In that scenario, if you sell your one year old bond in the secondary market, won’t your bond become a much attractive one than the current bond? This, in financier’s language, is called the ‘opportunity cost’. Therefore, in the secondary market, bonds give you an immediate higher return on falling interest rates and lower in escalating interest rates.
Needless to say, our New-Year’s eve party was all Balle-Balle after that. “Happy New Year, Jolly Uncle”, said I with a jolly smile.
dipankar.jakharia@gmail.com
