How do we think of bonds? We pay (to the borrower) a principal amount, say, ₹100 on January 01, and we expect to receive, say, a coupon interest of 8 per cent at the end of the year. But in between, the bond quotes at different prices of 95-105 during the calender year. This is driven by different factors like the underlying interest rate (set by the central bank), local liquidity, credit risk perception, ratings, etc.
The current yield is coupon interest divided by the current market price, so an 8 per cent coupon that sells in the secondary market for, say, ₹95 is giving a current yield of 8.42 per cent. If you are buying the bond in the secondary market for ₹95, you get a current yield of 8.42 per cent, but you also get a capital gain of ₹5 on maturity, which pushes up your yield-to-maturity (YTM) yield. The actual YTM cannot be calculated because a crucial piece of data is missing: When did we buy the bond, i.e., the capital gain of ₹5 is booked over what period? The book value of a bond is always at par because no recycled profits are allocated to bonds (like equity), but the market value of a bond fluctuates, as explained above.
For those who think that bonds are very safe, consider this: The yield in the bond market had fluctuated from 9.1 per cent to 7.92 per cent in 2014. In the example, that means that the price of the bond described above would have fluctuated between 88 and 101, i.e., an amplitude of 13 per cent. By comparison, a low-volatility stock might fluctuate 30 per cent. The higher end would be much more.
So let's see the equivalence between a stock and a bond. A stock has a certain par value similar to the principal amount in a bond, but over time, it develops a book value, which is more important. For a stock bought from the secondary market, the book value is now the par value, equivalent to the principal amount of a bond, except that there is no maturity of a stock, practically. Hence, a stock is a perpetual bond with no maturity date.
Now the earnings from a stock are of two kinds, both of which are used in the valuation of the stock. First is the earnings of the stock. Second is the dividend flows from the stock. The earnings, aka EPS, divided by the market price of the stock is the earnings yield, the inverse of the better-known P/E ratio. The dividend yield method is more difficult. Typically, the earnings yield should be at a premium to the risk- free interest rate, called an equity premium. So, for a risk-free interest rate of 8 per cent, currently you will get an equity premium, which, on average, would be 1.5 times the risk-free interest rate. That would mean 12 per cent, giving you a target earnings yield of 20 per cent. The inverse of that, the P/E, would be 5.
But remember, these are all moving parts. As the risk- free interest rate falls (which is what the clamour is all about just now), so will the equity premium, leading to a drop in the earnings yield, and hence an increase in the P/E ratio. The actual market moves very differently from this theoretical model because very few investors are rational and can restrain themselves from buying at stretched prices. The herd instinct is simply too strong. Just how crazy this can get is visible from the following example.
In 2001, at the peak of the IT boom, I valued Infosys as a bond. It was quoting at 189 times earnings, i.e., I was getting an earnings yield of 0.529 per cent but the earnings were growing at 135 per cent (in that particular quarter). So, would you pay ₹189 for ₹1 (of earnings) growing at 135 per cent per annum? Put it on a spreadsheet to see when you can get your money back; or better still, see when your earnings compound to deliver an earnings yield of a sensible 15 per cent on your investment.
Compare this to where Balrampur Chini, a dull, boring sugar stock was at that time. The earnings yield was to be at 33 per cent one year later. Yes, I had to anticipate an earnings upturn in the sugar cycle but the principle remains. While Infosys dropped 65 per cent in two years, Balrampur went up nearly 28 times.
But to get back to the principle of buying a stock like a bond, how many stocks obey the stringent constraints imposed by these parameters, just now? To get into the market, you have to forecast tomorrow's cost of capital; for example, inflation running at 4 per cent, real returns at 2 per cent, so a risk-free interest rate of 6 per cent. The equity premium will also come down to, say, 1 time the risk-free interest rate, giving an earnings yield of 12 per cent and therefore a P/E of 8.5 times. The current Nifty is at 17 times one-year forward earnings, giving an earnings yield of about 6 per cent.
Dividends are dependent on the company's reinvestment ratio, which is directly dependent on the company's underlying profitability. In theory, low-profitability companies should pay out higher dividends so that the money can be redeployed elsewhere; and vice versa for a high-profitability company to keep compounding as long as it can beat the cost of capital. In practice, human behaviour ensures just the opposite, where a low-profit company is usually struggling to pay off its debtors and tends to retain capital. The high-profitability company, however, does sometimes hold back dividends on the 'correct' logic. Sometimes, in widely held companies and in MNCs where the majority shareholder has other concerns, the dividend payout is deliberately kept high. But this whole thing is so messy that it completely destroys any pattern you might want to see. The dividend irrelevance theory of Modigliani and Miller (they still teach it) is completely discredited...and they gave a Nobel Prize for that.
In currency markets, there is an interest-rate parity theorem, which compares the risk-free interest rate in two underlying economies and values the forward (relative) value of the respective currencies such that a bond investor who switches from one currency to another would be indifferent at the end of the year, PROVIDED the high-interest currency depreciates according to the interest-rate differential prevailing. But this rarely happens, creating this interminable currency market volatility, which is the source of so much risk to the high-interest economy.
If we treat the forward premium as a bond coupon, then it is earned by the carry trader and paid by the high-interest economy. So, currency trading is very similar to bond trading except that you need to monitor the bond markets of both the economies....and take care of the temporary spikes that come from upheavals in the currency markets. So, while in actual practice, there is much more to currency trading, remember that the theoretical models treat it as a relationship between two bond markets. For natural exporters or global companies, there is a huge profit to be made by standing in both currency markets, using the theoretical models to value currencies and then comparing to the current reality and arbitraging the two valuations. There is an opportunity right now in the Euro.
Commodity markets are more difficult to trade than bonds, but they too operate on different interest rates. Some major commodities like oil and gold, for example, are often treated as currencies. If there is a material interest rate differential between the oil or gold market, it reflects the influence of some other factor, maybe a geopolitical development. Minor commodities like sugar and coffee might have different carry premia, which is driven by seasonal factors or crop expectations, over-stocking, etc. Still, lenders could hold inventory in exchange warehouses and sell in the forward market to capture the carry. This would determine the implied interest rate prevailing in that particular market, which can be compared to an 'equivalent' bond category.
The carry premia in various futures markets is often compared to the time value of a far-month option, which should theoretically be the same as the spreads prevailing in the various buckets of the futures markets. Any distortions represent opportunities for arbitrageurs. These 'structures' between and within futures/options markets create trading opportunities for 'defined risk' players, who operate with clear, structured risk-reward equations. Once probabilities are assigned to the various scenarios and there is adequate margin of safety, you allocate small amounts of capital in serial, like betting on a biased coin-toss.
The author teaches, trades and writes at spandiya.blogspot.com.
This column appeared in the January 2015 Issue of Wealth Insight.
This article was originally published on January 30, 2015.
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