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Good deal because price has dropped.

Thursday, January 19, 2017


"Don't ask barbers if we need a haircut."
There was a time when I enjoyed visits to the banks. As a boy, I was very interested in getting the highest interest rate possible for my savings. I enjoyed visiting the banks to update my savings passbooks when interest crediting became monthly instead of yearly. There were no auto update machines in those days but I didn't mind waiting in line for a teller.

I no longer enjoy visits to the banks. If I go to the bank, I run the risk of being accosted by bankers eager to sell me some products. Actually, these days, we don't even have to enter the banks to get accosted. Walking past a bank could be a frightful experience. Detour? I would if I could.

Recently, I had to visit the bank. It is my once a year compulsory visit, if you know what I mean.

The expected happened.

B: "This pays you 4% per year. Better than leaving your money in a fixed deposit."

AK: "How does it generate 4% per year for me?"


I was given a fact sheet and I was not surprised to see that it was a unit trust which had a big exposure to bonds.

B: "The unit price dropped. You are getting a better price now. Really good."

AK: "(OMG...) And do you know why the unit price has dropped?"

Awkward silence.


AK: "Would you be surprised if I tell you the unit price will drop further?"

B: "How do you know?"


I was not amazed nor amused.

AK: "Did you buy this yourself since you think it is a good deal?"

Awkward silence again.


AK: "Bonds pay their holders an agreed coupon. We know interest rates are going up and if we expect interest rates to go up by 1% this year, the market would demand a proportionally higher yield. Demanding an increase in yield from the current 4% to 5% would mean a 20% drop in unit price for this fund."

Awkward silence yet again.

Then, I knew how my maths teacher felt when I gave her a blank look after she explained to me some maths thing a long, long time ago.


You also blur? I also blur.

11 comments:

Evilbdboi said...

Get him a lifeline

AK71 said...

Hi Evil,

You are so kind. ;)

Unknown said...

Thanks AK for your webinar yesterday.
I find it more engaging and entertaining than blog posts and emails (of course these are very helpful too!).
KK

AK71 said...

Hi KK,

Oh, I cannot take credit for that. I was just a guest on the show. :)

In case others are not sure what this is:
The Fifth Person, 9pm, 18 Jan 17.

kael1n said...

hi, i think your math is wrong.

if a bond is valued at par at 4% coupon and market interest rates increase by 1% to 5%,

a 5-year tenor bullet bond's price will fall by about 4+%
even a 10-year bullet will fall by about 7+%

not that a fall in price is a good thing, but the fall is nowhere near the 20% you mentioned

AK71 said...

Hi kael1n,

I was referring to a 1% rise in risk free rate and not a market interest rate increase by 1% to 5%.

So, if the bond now offers a 4% yield, if the risk free rate goes up by 1%, Mr. Market will probably demand a 5% yield from the bond.

Bond price $1. Coupon 4c. 4%.
If market now wants 5% but coupon is still 4c. Bond price has to be 80c.

My math teacher told me I was pretty dense when it comes to numbers. So, I am sticking my neck out here. Very stress. -.-"

AK71 said...

Also, remember, we are talking about a bond fund here.

There is no maturity date.

kael1n said...

hi AK, thanks for response. Even if we are talking about a bond fund, what does the fund own. The fund owns bonds, most of which typically mature at some point. The fact that a bond matures and they roll the proceeds into a new bond continuously is a separate point.

whether it is an increase in risk free rate or increase market interest rate, i think we are saying the same thing, it will affect the price of the bond.

I think (and i am not 100% sure here) the part you are missing in your math is the return of the bond's principal. Maybe easier to illustrate using an example: Let's say a bond gives 4% coupon with 5-year maturity and the market thinks it should be a 4% yield, so it will be priced at par, i.e 100. The cashflows as follows:
Yr 1 - 4
Yr 2 - 4
Yr 3 - 4
Yr 4 - 4
Yr 5 - 104

as you correctly mentioned, regardless of the change in interest rates, the cashflow profile remains unchanged. If the price of the bond, falls from 100 to 80, the yield is not 5% but 9%...


AK71 said...

Hi kael1n,

Oh, I know what you are getting at now. Yes, I agree.

For a bond with a maturity date, we know when the investor is able to get back his capital (if there is no default).

In your example, if it is a 5 year bond ($1 with a coupon of 4c), if the price should fall to 80c, then, the yield is higher because at the end of the 5 year period you will get back $1 and not 80c. So, you will gain 20c upon maturity (on top of all the coupons received).

With a bond fund, because they hold a portfolio of bonds, it is not as clear cut. I don't know how to calculate the bond duration. So, in this case, I simply treat it as a perpetual from which I will never get back my capital but will forever receive the promised coupon. And, of course, you are right to say that this is too broad a stroke and, yes, to be realistic, I have most probably overestimated the downside. ;p

simplyme said...

My favorite questions to ask any sales person:
1) do u know why it's so cheap?
2) do u buy/use the item yourself?
3) will u continue buying/using the product in the next 10 years?

I think the authorities should clamp down severely on sales. Majority of sales people missell, misquote, misunderstand. I once had an RM recommended by a friend who said she was "fantastic" because she recommended good products. I had to correct her math when I met her and cautioned my friend against her advice. Interestingly, he came back and admitted she really had miscalculations but it was in his favour (due to the market conditions then) -.-"

They are truly one of the drivers of the saying: you work so hard to earn money to buy stuff you don't need. To impress people you don't like.

AK71 said...

Hi simplyme,

You were savvy enough to find out and not plonk down some money. Thumbs up.

I have a friend who simply passed $100K to a financial adviser after his brother told him that the adviser was very good. The last time I saw my friend, he told me that most of the money was lost.

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