Hello Everyone.
One thing is bugging me for some time. Let me explain bellow.
Say Ram has 100rs and Shyam as 100rs to save.
Ram decided invest is 100rs in a bond which is trading at exactly 100 with a coupon rate of 10% (for simplicity). The Bond matures in exactly 5 years.
Shyam decided to put his 100rs in a 5 year FD with annual interest rate pays 10%.
After 5 years, if both do nothing they get paid exactly the same amount.
But real life is different. Say in the very next day of buying the bond, interest rate moved up to 11%! So Ram’s bond immidiately adjusted to 96(approx). Ram decides to sell his bond and book the loss(ignore 1 day’s any coupon payment). At the same time Shyam for some emergency, prematurely withdraws his FD too. Since it is just a day, he doesn’t earn any interest in this FD but gets his principal of 100rs back.
Clearly Ram was penalised here because he invested his savings in bonds whose prices are marked to market while FD is not marked to market. So does that mean that instrument whose prices are not marked to market is better when interest rate moves up?
What type of bond it is? sovereign backed or not? FD’s are not fully backed by govt above certain limit but yeah FD’s failing is a black swan event.
What is your intention? want to trade or just want to eat interest earned?
Never a FD and bond will have same yield at same time, bonds with more than a year for sure will give higher yields than FD of same maturity as earlier comes with interest rate risk.
I think there will be penalty for breaking FD, even though small but will be there I think.
One can pledge both sovereign bonds and FDs to get some loan, not necessary to sell any of them.
Hii
Your replies, I think answers some other aspects of “Bonds vs FD” questions.
My specific question is more like a fundamental question. We are not talking about special events of any black swan things. Just normal market condition.
Why the Bond guy only lost? Why not FD guy? (any penalty on the premature withdrawal of FD is always on the interest payment, and not on principal, so FD guys always gets in principal back)
I am not sure on your understanding level of bond concepts, why do you think only bond is at loss and not FD, suppose you placed FD at 6 and bond also at 6 and if rates came down to 4% then bond prices can gain by 5 to 20% based on maturity and coupon. So according to your logic there is opportunity loss for fd right but we should not look like that, each one has it’s own way.
Hi Siva,
I think now I am getting what you said. In the case when the IR falls, then the bonds rise but no such gain in FD and if both are liquidated after the fall in interet rates, the bond holder gains but not the FD guy. Is it true? If so then now I understand. FD has no gain or loss on IR change which means when even though FD is advantageous in the case IR rises, but when it falls, it has opportunity cost lost. So they kind of cancel out. In Bonds it can translate into real gain or loss.
do you think my analysis tick the right boxes now?