31 October 2011

The layman's explanation of: Why Switch to Fixed Income Fund during Recession

Assume that I wish to borrow a lump sum of money from you, which I am going to repay 2 years later. In return, you think you need 10 percent return for the trouble.  On top of that, you require a bonus payment of $ 1,000 at the end of each year to sweeten the deal.

We put this in a contract. To recap, the conditions are:
1. You lend me a sum of money for 2 years. 
2. I will repay this principal amount in full, exactly 2 years from the date you transfer the money to me.
3. I will pay you $ 1,000 for the 1st year, and another $ 1,000 for the 2nd year.

Note that I did not commit giving you 10 percent ROI (Return of Investment) yet because I need to survey around what is the ongoing rate people are willing to borrow money.

Say, 2 weeks from now, I deduced that I need $ 10,000

Now, just before I request you to transfer the money to me, I realize everyone around us is willing to lend me $ 10,000 for 2 years, for a 8 percent return. 

Of course, it makes perfect sense for me to borrow from anyone who is willing to contend with 8 percent interest. However, I want to honour the contract we have put down in black and white.

So I approached you and told you this fact. Apparently, you too, have discovered that the ongoing market rate is 8 percent. With everyone around willing to accept 8 percent ROI, you will be the last person anyone would come to borrow money from if you insist on 10 percent.

You now agree to accept ROI of 8 percent on your principal, inclusive of the 2 bonus payments.

In order to avoid the hassle of altering any of the 3 terms in the contract earlier, the only factors that we can change here is the amount of principal you will lend me today. 

In MS Excel, key in this, without the quotes:  "=PV(0.08,2,1000,10000)"

You will now lend me $ 10,356, a little extra than $ 10,000 which I require.
(Note that if required ROI were 10 percent as previously, and everything being equal, you would have lend me $ 10,000)

The analogy here:
Me: Bond issuer
You: Bond buyer/institutional investor
$ 10,356 : Price of the bond
8 percent: Market current interest rate in direct correlation with Base Lending Rate (BLR)
2 years: Bond maturity duration

This explains why when market is down (characterized by lower interest rate and plunging stock market), your friendly neighbourhood UTC will ask you to buy or switch to Fixed Income  Fund. Most fixed income funds essentially consist of government and corporate bonds which goes up in value during economic recession. Generally, when the bond portfolio in fixed income fund rises in value, the Net Asset Value (NAV) of the fund goes up. Other factors such as the bonds' rating and duration to maturity also affect your investment return; lets save that for subsequent posts.

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