Rajen Gala

OPEN MARKET OPERATIONS Often, we come across the term called ‘OMO’. What is OMO? An Open Market Operation (OMO) is the buying and selling of government securities in the open market. It is done by the Reserve Bank of India. When there is excess liquidity in the market, the RBI intervenes and sucks it out by issuing bonds, among other means. At the same time, if the liquidity starts to dry up in the markets, the RBI intervenes and infuses liquidity by buying back the bonds that are with the investors. What is the outcome on account of OMO? When the RBI buys bonds from the market and infuses liquidity, the consequences are: It tends to soften interest rates. Fresh bonds can be issued at lower yields and the government can thus borrow at a reasonable cost. It enables corporates to borrow at favorable interest rates. It prevents the rupee from strengthening unnecessarily and thereby protects the interest of exporters. It may tend to increase inflation. If the RBI were to sell bonds instead and suck out the liquidity, the effect would be exactly the opposite. Thus, OMOs are an important instrument of credit control through which the Reserve Bank of India purchases and sells securities. Types of Open Market Operations RBI employs two kinds of OMOs: Outright Purchase (PEMO) – this is permanent and involves the outright selling or buying of government securities. Repurchase Agreement (REPO) – this is short-term and are subject to repurchase. To sum up: What : Open Market Operations (OMOs) are a means by which a central bank control’s the nation’s money supply by buying and selling government securities and / or other financial instruments. Why : It helps regulate interest rates and foreign exchange rates.

Debt Equity Ratio In life we should be grateful to all those who have helped us in making us what we are. So, who are these people we need to be indebted to? They are our teachers, mentors, leaders etc. who light up the path that we tread upon. We owe them our success. And in return they earn “Guru Dakshina” in the form of their fees. So, while we gather knowledge from our teachers and progress in life by earning wealth and fame, all that they receive is their professional fees and goodwill from their students. Even if we are unable to make the most of our education and fail to make it big in life the amount of professional fees remains the same. Hence the “Guru Dakshina” remains fixed irrespective of the outcome. This “Guru Dakshina” is similar to the debt, companies take from banks. Whether the companies deploy the money profitably or not they are liable to repay their debts. And of course, companies should be grateful or indebted to the banks who help them to succeed by providing capital at the right time. While we remember our teachers, we must not forget the teachers who never demanded their “Guru Dakshina” from us. Who are they? They are our parents. They laid the foundation of our lives. They taught us our values and beliefs. And if we stand tall today it is because of the platform they gave us earlier in life. But they never took a fee or asked for their share of “Guru Dakshina”. Why did they do that? They did that because for them their “returns” were directly linked with our well-being. Their happiness, their success and their “Guru Dakshina” was to see us succeed. Since they never asked for professional fees, their contribution cannot be termed as debt. So, what is it? Their participation in our lives can be compared with “equity” participation of investors in companies. Investors who participate by way of equities take the risks and do not demand a fee. They allow the company to perform without worrying too much about timely returns. In that sense they allow more “elbow room” to the management. Whether the company succeeds or fails they are part of its destiny. However, they earn their returns if the company turns profitable. Similarly, parents think of their children’s success as their returns. Thus while “debt” is like paying professional fees to teachers, “equity” is like the sharing of one’s fame and success with parents. Hope the concept of “Debt” and “Equity” has been made clear for you. Now let us look at the Debt : Equity ratio. So as per our understanding we can now see this ratio from a different perspective. While debt has to be serviced on time, “returns” for equity investors can be paid out of net surplus. So, if Debt : Equity ratio is 2:1 it means the company has larger debt on its books. Companies which are capital intensive have high ratios. Another interpretation of a high ratio could be that the management’s confidence in the business is high. But investors should realize that a very high Debt : Equity ratio also means higher debt obligations and hence accompanied risks. If the Debt: Equity ratio is 1:1 it means that the company does not have much debt obligations on its books. Software companies which have limited capital investments usually have a lower Debt : Equity ratio. Sometimes a low Debt : Equity ratio could also mean that the company is not aggressive enough. However, what is most important is the fact that Debt : Equity ratio might be a necessary measure to judge the health of a company but is not a sufficient measure to come to any conclusion. One would have to study other parameters like Gross and Net Profit, ROCE, ROE, etc. before coming to any sort of conclusion about the health of the company.

Significance of Yield in Bond Market Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. Setting the bond yield equal to its coupon rate is the simplest definition. The current yield is a function of the bond\’s price and its coupon or interest payment, which will be more accurate than the coupon yield if the price of the bond is different than its face value. When equity markets are bullish, we say “The Sensex has “gone up” or “Equity prices have “gone up” BUT When bond markets are bullish, we say “yields” have “gone down” Why?? When bond markets move up, we say that the “yields” have gone down whereas when bond markets fall, we say the “yields” have gone up. Thus, there seems to be an inverse relationship between the markets and the “yields” However, it is quite the opposite with Equity Markets where the “SENSEX” is said to go up with rising markets and go down with falling markets, Thus, there seems to be a direct relationship between the equity markets and the SENSEX. In equity markets a business offers its shares to investors who are willing to take a risk on the business succeeding and thereby making big gains. In a bond market the business raises debt capital where the investors invest money for a fixed period at a particular rate of interest. When the bond markets are bullish (positive) it means there are many investors who are willing to lend money. In such a situation the business can expect to raise capital at a lower interest rate or “lower yield” Hence, we say that “when bond markets are bullish the yields fall”. Let me explain with an example. Let’s say I issue a debt paper of ₹100 each at 10% interest p.a. This means that an investor who lends me ₹100 for one year will earn ₹10 at the end of the year. Thus, at the end of the year I will return ₹110 (₹100 + ₹10) In a bullish market there are several investors who want to invest and papers are in short supply. In such a situation, perhaps I would find an investor who is willing to pay ₹105 for my debt instrument for which I had paid ₹100 to the original issuer for earning a 10% interest. In this situation I become the issuer to the new investor who purchased the debt paper from me for ₹105. The earning of the new investor works out to be ₹110 – ₹105 = ₹5 And the amount of interest he earns works out to (Profit/Invested amount) x 100 = {5 / 105} % = 4.7% Thus, we see that when the market is bullish the yields come down and one is able to raise capital at lower interest rate.

BOND LADDERING Bond investing is much like a game of musical chair in which bond prices move to the tune of interest rates. Sometimes you might feel that you have no control over what happens to your bond portfolio with the future movements in interest rates. But familiarity with ‘bond laddering’, an investment strategy, could help deal with what is called reinvestment risk. How Bond Laddering Works A bond investor might purchase both short-term and long-term bonds in order to disperse the risk along the interest rate curve. That is, if the short-term bonds mature at a time when interest rates are rising, the principal can be re-invested in higher-yield bonds. If interest rates have hit a low point, the investor will get a lower yield on the reinvestment. However, the investor still holds those long-term bonds that are earning a more favourable rate. Essentially, bond laddering is a strategy to reduce risk or increase the opportunity of making money on an upward swing in interest rates. In times of historically low interest rates, this strategy helps an investor avoid locking in a poor return for a long period of time. However, The face value of each bond might be same. For example, a bond portfolio of Rs10 lakh may have 10 different bonds of Rs1 lakh each maturing after one year, two years, three years and so on. In such a situation, your bond portfolio would actually look like a ladder in which every year some of your bonds would be maturing, generating a steady cash flow. This cash flow, if you so like, can be reinvested again to create another rung of a bond ladder. style=\”text-align: justify;\”This kind of strategy ensures that your entire bond portfolio does not mature on the same date. Rungs By taking the total amount you plan to invest and dividing it equally by the total number of years for which you wish to have a ladder, you will arrive at the number of bonds for this portfolio or the number of rungs on your ladder. The greater the number of rungs, the more diversified your portfolio will be and the better protected you will be from any one company defaulting on bond payments. Height of the Ladder The distance between the rungs is determined by the duration between the maturity of the respective bonds. This can range anywhere from every few months to a few years. Obviously, the longer you make your ladder, the higher the average return should be in your portfolio since bond yields generally increase with time. However, this higher return is offset by reinvestment risk and the lack of access to the funds. Making the distance between the rungs very small reduces the average return on the ladder, but you have better access to the money. Well, reinvestment risk of a bond is something that arises due to future movements in interest rates. Other Benefits of Bond Laddering Bond laddering offers steady income in the form of those regularly occurring interest payments on short-term bonds. It also helps lower risk, as the portfolio is diversified because of the various maturation rates of the bonds it contains. In effect, laddering also adds an element of liquidity to a bond portfolio. Bonds by their nature are not liquid investments. That is, they can\’t be cashed in at any time without penalty. By buying a series of bonds with different dates of maturity, the investor guarantees that some cash is available within a reasonably short time frame. Bond laddering rarely leads to outsized returns compared to a relevant index. Therefore, it is usually used by investors who value the safety of principal and income above portfolio growth. It is a lot like ‘not putting all your eggs in the same basket’. Likewise, your entire bond portfolio should not mature on the same date. To Sum Up What: Bond laddering is an investment strategy that tries to minimize the risk associated with the future movement in interest rates. How: A bond portfolio using laddering would consist of bonds having same face value maturing on different dates at a regular interval. Why: Bond laddering strategy is useful because it helps in minimizing the reinvestment risk.