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Interest Bearing Securities: Role In Portfolio Management

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Question:

Discuss about the Interest Bearing Securities for Role in Portfolio Management.
 
 

Answer:

Introduction:

Money market is a segment of the financial market where the securities are traded for shorter term and the risk associated with the money market is comparatively lower than the capital market. On the other hand, capital market is that section of the financial, market where the securities are traded for longer term and the risk is higher than the money market. The securities, which yield interest, are referred as the interest bearing securities. There are two types of interest bearing securities. One is fixed interest-bearing securities and the other is variable interest securities. The key interest rate in the capital market includes interest on public corporation bonds, government bonds, and rates on deposit of long-term debentures (Cook et al. 2012). The interest bearing securities in the money market include Treasury bill, commercial paper, certificate of deposits, money market bonds. The interest rate is the yield, which is paid to the owner of the securities. There are different kinds of interest bearing securities depending upon the issuer of the instruments. The rate on such securities is guaranteed in terms of the real interest rate because it also takes into account the inflation rate.

Discussion:

There are different types of interest bearing securities. The securities to be issued depends on various factors such as the security offered by the loan issuer, maturity, the type of interest payments, nature of the issuer. The interest bearing financial instruments has a receivables right on the issuer of the loan. The return on such borrowed amount is given in the form of interest, which is also known as coupon. The coupon is either paid at a floating rate or fixed rate, which again depends upon the choice of the issuer. When the fixed rate loan is issued, then the interest is fixed for the whole term of the borrowing period (Faure 2015). On the other hand, in case of floating rate, the rate is fixed for three months and it is fixed four times on the basis of NIBOR interest rate. Some bonds are issued at zero interest rate.

 

The various types of interest bearing securities are as follows:

Debentures:

A debenture is a type of the debt instruments which is issued by the company which are raised for meeting the upcoming expenses and the short term capital. A debenture has a convertibility feature, which is attractive to the investors but yield lower interest rate. On the other hand, debentures which cannot be converted into equity bears higher interest rates. It is issued ,by corporations and companies that is secured by the general credit of the corporation rather than secured by specific assets (Canzoneri et al. 2012).  

Bonds:

Bonds are such financial instruments in which the issuer owes a certain amount of debt to the holder of the bonds and is under the obligation of paying interest rate as well as the principal amount at later date. The issue of bond is done at some fixed terms and the interest rate is paid at the fixed interval, it can be monthly, semi monthly, annually, and sometimes monthly. The public sector unit, corporate and the financial institutions typically issue bonds. There are several types of bonds such as executive bonds, tax savings bonds, institutional bonds, emerging market bonds , company bonds. The company bonds are at better quantity of risk because it is mainly dependant on the business enterprise. Such bonds are considered risks free which are issued mostly by the governments and countries. These bonds are considered risk free with respect to being redeemed at value, which is predetermined. However, there are always some amounts of default risk associated with the securities. In this regard, the bond  issuer pays to the bond holder some amount of risk premium or it may provide some collateral to the buyer of the bonds. The bond is redeemed as it has defined maturity term and the bond holder represent the creditor stake in the company issuing bonds (Cumming et al. 2014).

Certificate of deposits:

This is a financial product, which is issued by the banks, and this instruments is transferrable. The certificate of deposits is the registered form of funds, is regarded as the marketable form of receipts, and is deposited in a bank at specified interest rates. This negotiable instrument is transferrable and should not have a maturity less than seven days and it should not be more than one year. This financial instrument is liquid, bearing fixed interest rate, liquid and riskless money market instrument. It can be issue to associations, individual, corporation and trusts (Goyenko 2013).

Treasury bills:

Treasury bills are the discounted securities and are the borrowing instrument of the shorter term provided by the Government of India. The investors would be able to park their short-term surplus and at the same time, it would help in minimizing the market risks. It is interest bearing instrument which helps in raising the funds for capital and the amount to return is guaranteed along with the interest payment. It comes with the zero risk of default as they are the liabilities of the Government of  India. This provides the liquid market instrument to the investors. Investors can purchase T- bills of different maturities period depending upon the requirements of the investors (Chordia et al. 2013).

Commercial paper:

It is also one of the instruments of the money market, which is issued, by the corporations and large bank in order to meet the short-term obligations. The payment of the face value at the maturity is specified on the note and is promised by the issuing authority. This instrument is sold at a value lesser than the face value that is it is sold at a discount value. If the maturity on the note is higher, then the issuing institution is liable to pay higher interest rate. The interest rates are typically lower than the interest which bank pays. However, the rate fluctuated with the market scenario (Fong et al. 2015).

 

Inter corporate deposits:

It is a type of loan, which is extended by one corporate to another. However, it is not secured. The interest rate in this type of market is higher than the rates in the market and this is because the costs of funds for the corporate are higher than the banks. This type of security carries high amount of risks and is unsecured and the risk premium are built into rates.

Risks faced by the investors in investing in interest bearing securities:

The risks associated with the interest bearing securities arise due to the change in the price, which might happen during the holding period. It happens because there is a change in the market interest rate. The other part of risk arises from the default of the issuer regarding the repayment of the loan amount. Such securities are comparatively less risky on which full security are provided for payment. However, the loss of risk on the interest bearing securities is quite lower than that of the shares and stocks available in the capital market. When the market interest rate rises , the interest bearing instruments issued previously will fall if they have fixed rate of interest (Stigum 2013). This is because there is higher interest return on such loans as the loans issued in the current period would follow the market rates. On the other hand, the price of the instruments, which have been issued previously, would rise when there is a fall in the market interest rates. The various bonds are classified with regard to the credit risks as provided by the international rating agencies.

Various types of risks faced by the holder of interest bearing securities:

Market risks: this type of risk is related to the market and it is the risk that the market for such security says bond would fall which decline the value of the bonds and this would would fall regardless to the securities fundamental characteristics.

Interest rate risks: the interest bearing securities such as Treasury bills suffers from the interest rate risks. When the interest risk rises, the market value for debt tends to fall making it problematic for the investors to liquidate. This would definitely leads to loss on investments.

Selection risks: The risk associated with the investment in the chosen securities cannot be anticipated sometimes. This leads to the securities to underperform. The portfolio managers while selecting the securities to include in the portfolio mostly face this type of risk (Cumming et al. 2014).

Default risk: the risk is associated with the securities regarding making default in the repayment of the principal amount. The issuer can make default in the payment of the loan amount due to several reasons and if it is possible if the payment is not as per the documentation.

Inflation risks: the inflation risk affects the purchasing power of the investors. Since, there exists an inverse relationship between the price of bonds and the rate of interest. The interest rated becomes high due to inflation and this leads to fall in the bond price.

Liquidity risks: the holder of the security may find it difficult to liquidate the security and he might not be able to find the seller to sell off the securities. This would force him to sell the security at a lower price than the market value that is he would be compelled to sell it at the discounted price. Such type of bonds suffers from liquidity risk which has been downgraded or which is issued by the infrequent issuer or which has a lower credit rating.

 

Role of interest bearing securities in portfolio management:

One of the important and vital strategies of investment is inclusion of the interest bearing securities in the portfolio of the investors. This would help in stabilizing the portfolio. The volatility of the portfolio would be reduced to a significant level if the interest bearing securities such as bonds, fixed income securities form a part of the investor’s portfolio. The portfolio of the investors could be diversified by including such assets class and the diversification helps in mitigating the risks of the portfolio to some extent. If the portfolio risk is lower, then it would help in moderating downturn which would help the investors in focusing on their long term goals rather than reacting to the market movements which is for shorter term. Such securities would provide favorable return characteristics. The optimal portfolio is created when the investors considers the relation between the return and risks. Including interest bearing securities would provide meaningful diversification , this happens when the securities such as bonds are low , then the investor needs to buy the bonds and sell off the stocks. This would provide a way to rebalance the  portfolio (Martinsuo 2013).

Asset allocation:

Allocations of the assets are the primary delivery of the portfolio performance. In comparison to the security selection, market timing and other factors, the majority of the portfolio performance comes from the allocation of the assets. The important factor in determining the asset allocation is the risk tolerance level, that is the amount of risk, which the investor is able to tolerate in order to achieve the investment goals (Chang and Tian 2016). Let us consider an example, if the investor is expecting 8% return and it is recommended that 70% of investment is made in the aggressive stocks and 30% is made in the defensive stocks. The asset allocation can be revised to 60% and 40% if the stock performance is not good and more investment should be made in the government bonds and cash equivalent.

Convexity:

The changes in the duration with respect to the changes in the interest rate are given by the convexity. The price and the yield of the bonds yield a convex relation. The changes in the price of the fixed income securities with respect to changes in the interest rate are given by the convexity. A bond of 8% is less sensitive to 6% bond.

Convexity

If the yield of the bond falls to a low level, then there would be negative convexity. Therefore, the duration would decrease when the yield decreases. However, not all the convexity is beneficial to the portfolio. If the security exhibit positive convexity, then the bond price would appreciate if the interest rate falls. The portfolio managers can implement in the portfolio, the strategy of adding the positive convexity to hedge against the declining rate of interest (Nyawata 2013).

Duration and immunization:

The portfolio is immunized from the risk of changes in the rate of interest by using the duration. It is an important tool, which depicts the sensitivity of the portfolio towards the interest rate. Duration analysis helps in measuring the risks associated with the interest bearing securities. A concept of technique gap management is introduced in the duration in order to manage the risk of the portfolio. When such securities serve to lengthen the asset class liabilities, the duration gap tends to reduce. The task of the portfolio manager is to immunize the funds of the accumulated value against the interest rate movement at some future date. The portfolio ability to meet the investment obligations would remain unaffected, when the liabilities and assets are matched duration wise.

 

Recommendation:

The proportion of the interest bearing securities in the portfolio should be less or more than the stocks is dependent on the nature of the investors. If the investor is risk lover, then he would seek investing in aggressive stocks, on the other hand, if he is risk averse, he would include interest bearing securities in the portfolio. However, the decision is also influenced by the macroeconomic factors. The capital market instruments instrument has more risk of loss compare to the interest bearing instruments. Therefore, the risks adverse investors should invest in government bonds, treasury bills, commercial paper. The investors while making investment should consider the return on investment and the credit rating.

However, the average return form investment in the interest bearing securities is found to be lower and stable. If the bonds were yielding the higher return, it would be associated with the higher risk the investor is compensated with the higher return for the additional risks he is undertaking.

Conclusion:

It is a general tendency that the investors are always keen on investing in the less risky securities for the longer term. The investors should appoint the service of the portfolio managers for managing it, as there is some sort of risks associated with the interest bearings securities. The portfolio is rebalanced after gauging the performance of the securities and then the asset allocation is done. In order for the investors to get most of the benefit from the fixed income securities such as T-Bills and CD’s , the average duration should be increased when the interest rate declines so the negative impact is minimized and vice versa. However, the market for fixed income securities is no exception to the higher return and the higher risks.

 

Reference:

Canzoneri, M.B., Cumby, R.E. and Diba, B.T., 2012. Euler equations and money market interest rates: A challenge for monetary policy models.Journal of Monetary Economics, 54(7), pp.1863-1881.

Chang, K.C. and Tian, Z., 2016, July. Optimal asset allocation with mutual information. In 2016 19th International Conference on Information Fusion (FUSION) (pp. 1019-1026). IEEE.

Chordia, T., Sarkar, A. and Subrahmanyam, A., 2013. An empirical analysis of stock and bond market liquidity. Review of Financial Studies, 18(1), pp.85-129.

Cook, T.Q. and Duffield, J.G., 2012. Money market mutual funds: a reaction to government regulations or a lasting financial innovation?. FRB Richmond Economic Review, 65(4), pp.15-31.

Cooper, R.G., Edgett, S.J. and Kleinschmidt, E.J., 2012. New product portfolio management: practices and performance. Journal of product innovation management, 16(4), pp.333-351.

Cumming, D., Helge Haß, L. and Schweizer, D., 2014. Strategic asset allocation and the role of alternative investments. European Financial Management, 20(3), pp.521-547.

Farrell, J.L. and Reinhart, W.J., 2013. Portfolio management: theory and application. McGraw-Hill.

Faure, A.P., 2015. Money Market: An Introduction.

Fong, G., Pearson, C., Vasicek, O. and Vasicek, O.A., 2015. Bond performance: Analyzing sources of return. Finance, Economics, and Mathematics, 9(3), p.213.

Gibson, R., 2013. Asset Allocation: Balancing Financial Risk: Balancing Financial Risk. McGraw Hill Professional.

Goyenko, R., 2013. Treasury liquidity, funding liquidity and asset returns.Funding Liquidity and Asset Returns (July 16, 2013).

Kacperczyk, M. and Schnabl, P., 2013. How safe are money market funds?.The Quarterly Journal of Economics, p.qjt010.

Martinsuo, M., 2013. Project portfolio management in practice and in context. International Journal of Project Management, 31(6), pp.794-803.

Model, A.P., Diversification, I.I. and Roll’s, C.A.P.M., 2014. Investment Analysis & Portfolio Management.

Nyawata, O., 2013. Treasury bills and/or central bank bills for absorbing surplus liquidity: The main considerations. Journal of International Commerce, Economics and Policy, 4(02), p.1350011.

Stigum, M.L., 2013. The money market. McGraw-Hill Professional Publishing.

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