Navigating through floating and inflation-indexed bonds

In Armenia, many people typically save money by depositing it in banks. However recently, some investors are starting to realize that there might be better ways to grow their money. They realize that just keeping money in a bank might not be the best option as they learn more about other opportunities, such as investing in bonds. The bond market is becoming more popular, thanks to support from regulators, exchanges, issuers, and investment firms. This means more people are thinking about spreading out their investments beyond just using banks.

Traditionally, Armenians have felt safe putting their money in banks, but now they're exploring the bond market for potential benefits. Through exchanges (Armenian Securities Exchange AMX) and investment firms, people can now invest in various types of bonds, such as government or corporate bonds with fixed interest rates, or government bills with no interest (zero-coupon Treasury bills) issued by the Ministry of Finance of the Republic of Armenia.

This shift toward investing in bonds shows that investors are becoming more aware of the advantages bonds can offer, such as spreading out risk, generating income, and increasing the value of their investments.

As Armenia's investment options grow, it's becoming clearer that simple exchange-traded bonds could be more convenient and potentially more rewarding for those looking to improve their financial situation. Researching specialized bond options, such as those linked to interest rates or inflation, could provide investors with additional strategies for navigating market fluctuations and achieving their financial objectives. These particular types of bonds aren't yet available on the Armenian market, but if introduced, they could offer investors even more flexibility and protection against changes in the economy.

First, let's review some bond market basics:

At its core, a bond is a debt instrument that is a loan made by an investor to a borrower, usually a corporation or government agency. The bond issuer agrees to pay the investor a predetermined principal amount (face value) of interest over a specified period, known as the coupon rate, and to repay the face value on a pre-determined day, called the maturity date.

Zero-coupon bonds: These bonds are issued at a discount to their face value, with no periodic interest payments. Investors purchase them at a reduced rate and receive their full face value at maturity, effectively realizing the accumulated interest.

Fixed-rate bonds: These are regular-rate bonds whose interest rate remains the same until maturity. The price of these bonds rises or falls depending on what happens to interest rates.

Bond valuation: This means figuring out how much the bond is worth right now. It depends on how much money the bond will make in the future, and how much that future money is worth now. If the interest rates in the market are higher than what the bond pays, it's worth less. If they're lower, it's worth more. Various other factors, such as the credit quality of the issuer, the maturity of the debt, the availability of collateral (if there's anything valuable that can be taken if the loan isn't paid back), the amount of the issue, the liquidity of the bonds, and the activity of market makers, can also affect bond prices.

Exploring floating bonds: dynamic interest rate bonds

Floating bonds, or floating-rate bonds, or just floaters, differ in that interest rates are periodically adjusted based on a certain base rate (such as LIBOR or the Treasury bills rate) plus a predetermined spread. In the case of Armenia, those could be linked to the rates on bonds issued by the Ministry of Finance, or Central Bank of Armenia rates (refinancing rate, Lombard repo rate, deposit rate). This distinctive feature makes floating-rate bonds less sensitive to fluctuations in interest rates compared to fixed-rate bonds.

The interest rate on floating assets is reset at regular intervals, usually every three or six months, depending on prevailing market conditions. As interest rates rise, coupon payments increase, offering investors a natural protection from inflation. Conversely, in the face of lower interest rates, coupon payments are reduced, which creates a potential disadvantage.

Investors considering floaters should take into account the credit quality of the issuer, as higher-quality issuers typically offer narrower spreads compared to the base rate, while lower-quality issuers compensate for increased risk with wider spreads.

Using inflation-indexed bonds: protecting against a decline in purchasing power

Inflation-indexed bonds, commonly referred to as inflation-linked bonds or TIPS (Treasury inflation-protected securities), are designed to protect investors from the devastating effects of inflation. Unlike conventional bonds, the underlying value of inflation-indexed bonds is periodically adjusted to reflect changes in the consumer price index (CPI) or comparable inflation index.

In addition, coupon payments on inflation-indexed bonds are indexed to inflation, providing investors with a real rate of return above inflation. Hence, as the cost of living increases, interest payments on inflation-indexed bonds increase accordingly, preserving the purchasing power of investors' capital.

For investors seeking to hedge against inflation and maintain their real returns, allocating a portion of their portfolio to inflation-indexed bonds may be a smart strategy, especially in times of high inflationary pressures.

Therefore, it is crucial for retail investors entering the bond market to understand the intricacies of specialized instruments such as floating bonds and inflation-indexed bonds. While zero-coupon and fixed-rate bonds are fundamental elements, exploring these alternatives can provide opportunities for income generation, inflation protection, and risk management.

However, successfully navigating the complexities of the bond market requires expertise. Therefore, before deciding to invest in these instruments, retail investors need to seek guidance from an experienced market participant. A market professional can offer tailored insights aligned with individual financial goals, risk tolerance, and investment horizon. They can evaluate the appropriateness of different types of bonds and other securities within a diversified portfolio, and provide valuable perspectives on market dynamics, potential risks, and strategies for maximizing returns. By consulting with a professional market participant, investors can make informed decisions and effectively navigate the bond market terrain, ultimately optimizing their investment outcomes and financial security. ?

Authors

• Grzegorz Kucharski, Chief Strategy Officer,? Management Board Member of Armenian Securities Exchange
• Elizar Bubnov,? Director Cross Asset Structuring, Dimension Investments