Bonding The World A Unified Way of Looking At All Markets



How do we think of Bonds? We pay (to the borrower) a Principal amount, say, Rs.100 on the 1st of January and we expect to receive, say, a coupon Interest of 8% at the end of the year. But in between, the Bond quotes at different prices of 95-105 during the calendar year. This is driven by different factors like the underlying Interest Rate (set by the Central Bank), local liquidity, credit risk perception, ratings, etc.

Declaimer: This article written was originally in December 2014, and some of the data points may be outdated.

Explain the current yield

The Current Yield is Coupon Intt/ Current Market Price, so an 8% coupon that sells in the secondary market for, say, Rs.95, is giving a Current Yield of 8.42%. If you are buying the Bond in the secondary market for Rs.95, you get a Current Yield of 8.42%, but you also get a Capital Gain of Rs.5 on maturity, which pushes up your Yield-to-Maturity (YTM) yield. The actual YTM cannot be calculated because a crucial piece of data is missing….when did we buy the Bond, hence the capital gain of Rs.5 is booked over what period? The Book Value of a Bond is always at par because no recycled profits are allocated to Bonds (like in Equity), but the market value of a Bond fluctuates, as explained above.

For those who think that Bonds are very safe, consider this: the Current Yield in the Bond market has fluctuated from 9.1% to 7.92% this year. In the example, that means that the price of the Bond described above would have fluctuated between 88 and 101, i.e. an amplitude of 13%. By comparison, a low-volatility stock might fluctuate 30%. The higher end would be much more.

So let’s see the equivalence between a stock and a bond. A stock has a certain par value, similar to the Principal Amount in a Bond, but over time, it develops a Book Value, which is more important. For a stock bought from the secondary market, the Book Value is now the par value, equivalent to the Principal Amount of a Bond. Except that there is no maturity of a stock, practically. Hence a Stock is a perpetual Bond with no maturity date.

The Valuation of the stock

Now the earnings from a stock are of 2 kinds, both of which are used in the valuation of the stock. First is the earnings of the stock, and second is the dividend flows from the stock. The earnings, a.k.a. EPS/ Market Price of the stock is the Earnings Yield, the inverse of the better-known P-E ratio. The Dividend Yield method is more difficult, typically the Earnings Yield should be at a premium to the Risk-Free Interest rate, called an Equity Premium. So, for a Risk-Free Interest Rate of 8% currently, you would get an Equity Premium, which, on average, would be 1.5 times the Risk-Free Interest Rate. That would mean 12%, giving you a target Earnings Yield of 20%. The inverse of that, the P-E would be 5.

But remember, these are all moving parts. As the Risk-Free Interest rate falls (which is what the clamor is all about just now), so will the Equity Premium, leading to a drop in the Earnings Yield, and hence, an increase in the P-E ratio. The actual market moves very differently from this theoretical model, because very few investors are rational, and can restrain themselves from buying at stretched prices. The herd instinct is simply too strong. Just how crazy this can get is visible in the following example:

In 2001, at the peak of the IT Boom, I valued Infosys as a Bond. It was quoting at 189 times earnings, i.e. I was getting an Earnings Yield of 0.529%, but the earnings were growing at 135% (in that particular quarter). So would you pay Rs. 189 for Rs.1 (of earnings) growing at 135% per annum. Put it on a spreadsheet to see when you can get your money back; or better still, see when your earnings compound to deliver an Earnings Yield of a sensible 15% on your investment.

Compare this to where Balrampur Chini, a dull, boring, sugar stock was at that time. The Earnings Yield was at 33%, one year later. Yes, I had to anticipate an earnings upturn in the sugar cycle, but the principle remains. While Infosys dropped 65% in 2 years, Balrampur went up nearly 28 times.

The  principle of buying a stock

But to get back to the principle of buying a stock like a Bond, How many stocks obey the stringent constraints imposed by these parameters, just now? To get into the market, you have to forecast tomorrow’s Cost of Capital, e.g. inflation running at 4%, real returns at 2%, hence a Risk-Free Interest Rate at 6%. The Equity Premium will also come down to, say, 1 time the Risk-Free Interest Rate, giving an Earnings Yield of 12%, and therefore, a P-E of 8.5 times. The current Nifty is at 17 times 1-year Forward earnings, giving an Earnings Yield of about 6%.

Dividends are dependent on the company’s reinvestment ratio, which is directly dependent on the company’s underlying profitability. In theory, low profitability companies should pay out higher Dividends, so that the money can be redeployed elsewhere. And vice versa, for a high-profitability company to keep compounding as long as it can beat the Cost of Capital. In practice, human behavior ensures just the opposite, where a low-profit company is usually struggling to pay off its debtors and tends to retain capital. The high profitability company, however, does sometimes hold back Dividends on the ‘correct’ logic. Sometimes, in widely held companies, and in MNCs where the majority shareholder has other concerns, the Dividend Payout is deliberately kept high. But this whole thing is so messy, it completely destroys any pattern you might want to see. The Dividend Irrelevance Theory of Modigliani-Miller (they still teach it) is completely discredited…..and they were given a Nobel Prize for that.

In Currency Markets, there is an Interest Rate Parity Theorem, which compares the Risk-Free Interest rate in the 2 underlying economies, and values the Forward (relative) Value of the respective currencies, such that a Bond investor who switches from one currency to another, would be indifferent at the end of the year, PROVIDED the high-interest currency depreciates according to the interest rate differential prevailing. But this rarely happens, creating this interminable currency market volatility, which is the source of so much Risk to the high-interest economy.

If we treat the Forward Premium as a Bond coupon, then it is earned by the carry trader and paid by the high-interest economy. So currency trading is very similar to Bond trading, except that you need to monitor the Bond markets of both economies….and take care of the temporary spikes that come from upheavals in the currency markets. So while in actual practice, there is much more to currency trading, remember that the theoretical models treat it as a relationship between 2 Bond markets. For natural exporters or global companies, there is a huge profit to be made by standing in both currency markets, using the theoretical models to value currencies and then comparing to the current reality and arbitraging the 2 valuations. There is an opportunity right now in the Euro, which I articulated in my column of Sep, ’14.

Commodity markets are more difficult to trade as Bonds, but they too, operate on different interest rates. Some major commodities, like oil and gold, for example, are often treated as currencies. If there is a material interest rate differential between the oil or gold market, it reflects the influence of some other factor, maybe a geopolitical development. Minor commodities like sugar and coffee, might have different carry premia, which is driven by seasonal factors or crop expectations, over-stocking, etc. Still, lenders could hold inventory in exchange warehouses and sell in the Forward market to capture the Carry…this would determine the implied Interest Rate prevailing in that particular market, which can be compared to an ‘equivalent’ Bond category.

The Carry premia in various Futures markets is often compared to the time value of a far-month Option, which should theoretically be the same as the spreads prevailing in the various buckets of the Futures markets. Any distortions represent opportunities for arbitrageurs. These ‘structures’ between and within Futures/ Options markets create trading opportunities for “defined Risk” players who operate with clear, structured Risk-Reward equations. Once probabilities are assigned to the various scenarios, and there is an adequate Margin of Safety, you allocate small amounts of capital in serial, like betting on a biased coin- toss.

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