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Public Sector Undertakings (PSU) Bonds

Public Sector Undertakings (PSU) Bonds

Discuss Public Sector Undertakings (PSU) Bonds within the Financial Management ( FM ) forums, part of the Resolve Your Query - Get Help and discuss Projects category; PSU are medium and long term obligations issued by public sector companies in which the government share holding is generally ...



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Public Sector Undertakings (PSU) Bonds
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Public Sector Undertakings (PSU) Bonds - October 18th, 2010

PSU are medium and long term obligations issued by public sector companies in which the government share holding is generally greater than 51%. some PSU Bonds carry tax exemptions. the minimum maturity is 5 years for taxable bonds and 7 years for tax-free bonds. PSU bonds are generally not guaranteed by the government and are in the form of promissory notes transferable by endorsement and delivery.

Debt Investment Strategies – An Aid for Debt Portfolio Management:
let us have a look at some debt investment strategies adopted by the debt portfolio managers.

Buy and Hold:
historically, in India, UTI and many of the other mutual funds tended to invest in high yielding debt securities that gave adequate returns on the overall portfolio. the returns are considered sufficient to reward the investors. Therefore, the funds would just encash the coupons and hold the bonds until maturity. these fund managers will tend to avoid bond with call provisions, to counter the prepayment risk.
it has to be understood the strategy holds good as long as the general interest rate level are stable. if yields rise, the price of bonds will fall. hence, while the fund may generate sufficient current income according to original target, it will incur a capital loss on its portfolio as and when revalued to current market price. another risk on the portfolio, particularly if its maturities are long, is the risk of default by the issuer.

Duration Management:
if Buy and Hold is like Passive Fund Management, Duration Management is like Active Fund Management. this strategy involves altering the average duration of bonds in a portfolio depending upon the fund manager’s expectations regarding the direction of interest rates. if bond yields are expected to fall, the fund manager would buy the bonds with longer duration and sell bonds with shorter duration, until the fund’s average duration becomes longer than the market’s average duration. based as the strategy is on interest rate anticipations, it is akin to the Market Timing Strategy for equity investments.

Credit Selection:
some debt managers look to investing in a bond in anticipation of changes on ots credit rating. an upgrade of a bond’s credit rating would lend to increase in its price, thereby leading to a superior return. the fund would need to analyze the bond’s credit quality so as to implement this strategy. usually, debt funds will specify the proportion of assets they will hold in instruments of different credit quality/ratings, and hold these proportions. active credit selection strategy would imply frequent trading of bonds in anticipation of changes in ratings. while being an active risk management strategy, it does not take away the interest rate, prepayment or credit risks that are faced by any debt fund.

Prepayment Prediction:
As noted earlier some bonds allow the issuers the option to call for redemption before maturity. a fund which holds bonds with this provision is exposed to the risk of high yielding bonds being called back before maturity when interest rates decline. the fund manager would therefore strive to hold bonds with low prepayment risk relative to yield spread. or try to predict the course of the interest rates and decide what the prepayment is likely to be, and then increase or decrease his exposure. in any case, the risks faced by such fund managers are the same as any other. what matters at the end is the yield performance obtained by the fund manager.

Interest Rates and Debt Portfolio Management:
no matter which investment stragtegy is followed by a debt fund manager, debt securities are always exposed to interest rate risk, as their price is directly dependent on them. while they may yield fixed rates of returns, their market values are dependent on interest rate movements, which in turn affect the performance of fund portfolio of which they are a part. hence, it is essential to understand the factors that affect the interest rates. while this is an intricate subject in itself, we have summarized below some key elements that have a bearing on interest rate movements:

Inflation: simply put, inflation is the percentage by which prices of goods and services in the economy increase over a period of time. this increase may be on account of factors arising within the country – change in production levels, mechanisms for distribution of goods, etc, and/or on account of changes in the country’s external balance of payments position. in india , inflation is generally measured by the Wholesale Price Index although t he Consumer Price Index is also tracked. when the inflation rate rises, money becomes dearer, leading to an increase in the general level of interest rates.

Exchange Rate: a key factor in determining exchange rates between any two currencies is their relative purchasing power. Over a period, the relative purchasing power between two currencies may change based on the performance of the respective economies. the consequent change in exchange rates can affect interest rate levels in the country.

Policies of the Central Bank: the central bank is the apex authority for regulation of the monetary system in a country. in India, this role is played by the Reserve Bank. the RBI’s policies have a strong bearing on interest rate levels in the economy. if the RBI wishes to curb excess liquidity in a monetary system, it could impose a higher liquidity ratio on banks and institutions.

This would restrict credit leading to an increase in interest rates. Similarly, and increase in RBI’s bank rate has the effect of increasing interest rate levels. RBI may also undertake open operations in Treasury Bills and Government securities with the intention of restricting / relaxing liquidity, thereby impacting the interest rates.

Use of Derivatives for Debt Portfolio Management:
as explained above, a debt portfolio is always exposed to the interest rate risk. hence, derivatives contracts can be used to reduce or alter the risk profile of the portfolios containing debt instruments. interest rate derivatives contracts can be exchange traded or privately traded (on the OTC market). thus, a portfolio manager can sell interest rate futures or buy interest rate ‘put’ options, usually on an exchange, to protect the value of his debt portfolio. he can also buy or sell forward contracts or swaps bilaterally with other market players on OTC market.

in india, interest rate swaps and forward rate agreements were introduced in 1999, though the market for these contracts has not yet fully developed. in 2004, the National Stock Exchange has introduced futures on Interest Rates. interest rate options are not yet available for trading on exchange.
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