S B M - A I: Tudy of Various Factors Affecting Return in OND Arket Case of Ndia

Article No.
10
STUDY OF VARIOUS FACTORS AFFECTING

RETURN IN BOND MARKET – A CASE OF INDIA
Dr. Anurag Agnihotri

Professor, College of Vocational Studies, Delhi University
Abstract: This paper will study the impact of different macroeconomic factors on the bond Return such as
inflation, USD INR spot rate, crude price and RBI cash balance. The paper will give comparative analysis
of impact of various factors on bond Return against. Finally, the paper, being based only upon the statistical
analysis, gives conclusion based upon the historical analysis of the available data. Along with the above
assumption, our study considers that the inflation data are collected on weekly basis. This research has
found some kind of relation between these chosen variables and the bond Return of different maturities.
While some of the factors have more correlation with the bond prices, others are quite insignificant in
affecting the Return. The results of regression model also depicted that the bonds of different maturities
generally move together with any given variable i.e. any variable would affect the bond price of shorter
maturity same as that of longer maturity.
Keywords: Bond market, Macro Economics, Cash Balance, Comparative Analysis of bonds
Introduction:
The movement of return curve is a complicated issue for considering various factors
affecting this movement in different ways which varies with respect to time and market
conditions. This paper will study the impact of different macroeconomic factors on the
bond Return such as inflation, USD INR spot rate, crude price and RBI cash balance. The
paper will give comparative analysis of impact of various factors on bond Return against.
Statistical tool like multiple regressions is considered for the analysis of three years of
data i.e 2011- 12 to 2013-14. It was observed that interest rate risk is connected to
maturity of bonds. However, maturity is not a precise mechanism for measuring this risk
because there is a significant difference between nominal maturity and effective maturity
of bonds. This is especially true when there are intermediate cash flows involved.
Duration is one mechanism that helps us at least reduce the problems of maturity
matching. In this section researcher will try to measure duration, its use duration to
measure interest rate risk exposure.
AIMA Journal of Management & Research, May 2015, Volume 9 Issue 2/4, ISSN 0974 – 497 Copy
right© 2015 AJMR-AIMA
Duration is the weighted average time over which the cash flows from an investment are
expected, where the weights are the relative present values of the cash flows. It is an
alternative to maturity for expressing the time dimension of an investment. When you
focus on maturity you ignore the fact that cash benefits are received before the maturity
date. The value of bond is based on early payments are discounted less than those
received later, Differences in discounted value become more pronounced as time
increases, effective maturity may differ from contractual maturity. The duration is a
measure of effective maturity. Two bonds with the same duration but different maturities
have more in common than two bonds with the same maturities but different durations.
One can calculate the duration of bond as:
N N
 CFt .DFt .t  PV .t t
D t 1
N
 t 1
N
 CF .DF
t 1
t t  PV
t 1
t
Where: CFt = cash flow received on the bond at the end of period t
DFt = Discount factor = 1/(1 + R)t
R = Yield or current market rate
PVt = Present value of cash flows at the end of period t.
Finally, the paper, being based only upon the statistical analysis, gives conclusion based
upon the historical analysis of the available data. Along with the above assumption, our
study considers that the inflation data are collected on weekly basis. This assumption
eliminates this time mismatch of data in order to conduct the statistical analysis.
REVIEW OF LITERATURE
The Return curve, which plots a set of interest rates of bonds of different maturities,
describes the relationship among short-term, medium-term, and long-term rates at a given
point in time. It has been the subject of much research in the finance literature, because it
is the natural starting point for pricing fixed-income securities and other financial assets.
Baker (1996) explain that illiquidity to the costs of executing a transaction in the capital
markets. A cost of illiquidity exists because buyers and sellers must pay a price
concession to execute orders quickly. Illiquidity is a property only of a non-frictionless
market related to trading cost where trading costs like direct transaction cost, bid-ask
spread, market impact cost, delay and search cost are attributable to illiquidity. Amihud
and Mendelson (1991) Hasbrouck and Schwarts, 1988) expressed the similar views.
Groth and Dubofsky (1992), and Bernstein (1987) reaffirmed Schwartz by saying that
there is no single, unambiguous, theoretically correct measure of liquidity. Despite the
difficulties of precisely defining and measuring market liquidity, most researchers prefer
some quantitative liquidity measure. Common liquidity proxies include bid-ask spreads,
trading volume, and trading turnover. One common measure of immediacy is the bid-ask
spread, either absolutely or relative to some base price. It is the price that market makers
impose for liquidity services. Roll, (1970) McCulloch, (1987) explained that the bid-ask
price can be a proxy for liquidity since the trader, unsure of the true price of an illiquid
bond, is prone to require a high margin for error. Also an illiquid bond is difficult to
locate and deliver. In both cases, a high bid-ask price indicates a relatively illiquid bond.
However, the traders are likely to use larger spreads in volatile periods, since, in such
periods, uncertainty about illiquid bonds price is larger. However, the bid-ask spread is
more directly a measure of transactions cost than liquidity and suffers from several
shortcomings as a liquidity measure. First, spread alone does not capture the ability of the
market mechanism to absorb a dollar volume of trading without disturbing price. Sarig
and Warga (1989) exclaimed that a bonds liquidity tends to decrease with its age. Seidner
(1992) and Graham (1962) explained that a bonds age and time-to-maturity upon
issuance are correlated, the illiquid bonds are more prevalent among long-maturity bonds
rather than short-maturity bonds. However, inverse relationship between price risk
(refinancing risk) and interest risk further complicates the effect of maturity on liquidity.
Bonds with distinctive features may be perceived differently by investors. Darst (1975)
explained that the issuing firms usually view convertible securities as future common
stock rather than debt, and are generally subordinated to other straight debt of the issuer.
Pinches (1973) rated the convertible bonds one class below that of a straight debenture
issue of the same company. Graham (1962) found out that the coupon rate tended to vary
inversely with the ability of the firm to pay it. A strong company borrows at lower
coupon rate, although it can afford to pay more than a weak company. Hence, a low
coupon rate will not be a poor feature for a bond investment. Fabozzi, (1995) explained
that floating rate bonds are complex debt instruments as the benchmark rate and the reset
period make the coupon rate fluctuate and thus the bond prices change. The liquidity of
floating-rate bond issue is determined by the investors recognition of the floating-rate and
the interest rate risk. Wongkomol (1997) found that the sharp rise in the overnight inter-
bank rate occurs when most large banks have to hold funds in preparation to meet tax
payments and reserve requirements; so with less available funds for bond investment, the
bond secondary market liquidity becomes low. Therefore, spread between return on
promissory note and fixed-income funds has an influence on the Thai bond market; as
with narrow spread, fixed-income fund managers re-evaluate their exposure and shorten
the duration of their portfolios in light of continuing uncertainty. Mukherjee and
Atsuyuki (1995) explain that exchange rates as one of the macroeconomic factors exhibit
a positive relationship between itself and the stock price. The exchange rate fluctuation is
a critical factor for the foreign investors in the security market. The secondary security
market liquidity increases when foreign currency appreciates. However, the fluctuation of
exchange rate also increases the exchange risk of the investment when the foreign
investors transfer their investment back. The fluctuation of exchange rate may have a
minor impact on secondary bond market liquidity particularly when foreign investors do
not play an active role in bond trading.
Collin-Dufresne, Goldstein, and Martin (2001) explain that there are positive and
negative correlations and Interplay of factors affecting bond Returns. The more volatile
high Return bonds have a 20-30% impact in Returns due a change in the credit risk
quality of the bond.
Research Methodology
For this paper, I have used the secondary data which was collected from the website of
RBI, money control, IMF, World bank, federal bank. The data which was collected from
the above resources was tabulated and put to statistical test. For this paper, I have taken
macro economic variables such as inflation, spot rate, interest rate, repo, reverse repo
rates and crude oil prices. Then I used the multiple regression models. The results
obtained were then analyzed.
DATA ANALYSIS
The data was studied with the help of correlation and regression between different
variables. Bond Returns have positive correlation with all factors except USD INR Spot
Rate and Reverse Repo Amount. The positive correlation indicates that the bond Return
moves in the same direction as that of these factors if they are considered in isolation.
The correlation table explains that inflation has higher positive correlation than that of
other variables. Economic growth affects long-term interest rates through inflation
expectations. Inflation expectations are generally the main driver of long-term interest
rates. The increase in interest rate affects the Return in the similar manner. The increase
in Return reduces the bond price. Looking at the output across all maturity bonds, it can
also be concluded that inflation has higher positive correlation with the Return for low
maturity bonds and it declines gradually when the maturity period increases. This
happens due to the sentiments driving the bond market. If the bond market believes that
inflation risks are big enough to prompt the RBI to raise interest rates, short-term interest
rates will rise faster than long-term interest rates and thereby flatten the Return curve.
Crude oil price have also high positive correlation as per the table. Crude price has
indirect impact on the bond Return. Increase in crude price increases the cost of
production of goods, resulting a high inflation. That ultimately increases the bond Return.
USD-INR Exchange rate has negative correlation on bond Return as per the statistical
analysis. Empirical analysis suggests that appreciation of dollar against rupee makes the
market unattractive for investments. That reduces the cash inflow into the market and
hence the reduction of interest rate. That pushed the bond Return in a negative direction.
Reverse Repo Balance with RBI shows strong negative correlation with bond Return.
Reverse repo amount shows the deposits of the banks with RBI. An increase in this
deposit reduces the liquidity in the market. This in turn reduces the interest rate and
ultimately the bond Return.
Table 1: Pearson Correlation of Bond return and Inflation
Pearson Bond Return
Correlation 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 10 year 11 year
Inflation 0.794 0.741 0.602 0.584 0.684 0.647 0.657 0.646 0.591 0.602
Table 2: Pearson Correlation of Bond return with respect to spot rate, crude oil
price, Repo, reverse repo rate
Bond Return
Pearson
Correlation 1 2 3 4 5 6 7 8 10 11 year
year year year year year year year year year
USD INR Spot - - - - - - - - -0.589 -0.564

Rate 0.631 0.655 0.564 0.772 0.580 0.543 0.518 0.532
Crude Prices 0.628 0.681 0.687 0.521 0.698 0.712 0.693 0.741 0.684 0.687
Reverse Repo - - - - - - - - -0.538 -0.529
Amt 0.809 0.723 0.529 0.670 0.585 0.540 0.526 0.497
Repo Amount 0.405 0.387 0.325 0.173 0.352 0.297 0.330 0.350 0.294 0.325
Regression models:
The coefficient of determination (R-square) has significantly higher value 0.8 - 0.9 (close
to 1) for short maturities (Y1 - Y4). The value of R-square falls into an average of 0.6 -
0.7 for longer maturities. This goes to show that the regression equations obtained from
the analysis capture good amount of total variance of data for short maturity bonds. The
five market variables contribute to the bond Return fluctuation in a significant manner.
This would allow capturing future Return movements for short term bonds in precision.
At the same time the comparatively low R-square value for long maturity bonds indicates
the availability of other significant factors those impact the bond Return.
Table 3 : Statistical result of bond returns
Bond Return
1 2 3 4 5 6 7 8 10 year 11 year
year year year year year year year year
R square 0.894 0.836 0.623 0.723 0.704 0.648 0.637 0.660 0.627 0.623
Adjusted R 0.891 0.831 0.609 0.711 0.695 0.634 0.625 0.648 0.614 0.609
square
This indicates the existence of negligible autocorrelation among the error terms.
Autocorrelation signifies the correlation between the error terms associated with the
coefficient of the variables. For a model to be consistent and error free, a low
autocorrelation is desired.
Table 4 : Auto correlation and bond return

Bond Return
Auto-
correlation 1 year 2 year 3 4 5 6 7 8 10 year 11 year
year year year year year year
Durbin - 0.372 0.286 0.219 0.236 0.203 0.277 0.225 0.275 0.217 0.219
Watson
Variance Inflation Factor (VIF) values across all the maturities are below 10. This
signifies that there exists very low correlation among the independent variables. Even if
the correlation matrix shows some kind of correlation among the variables,that has no
significance when we consider the model as a whole.
Table no 5
Muti Bond Return
collinearity 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 10 year 11 yr
Inflation 4.536 4.570 4.536 2.988 4.488 3.939 4.536 4.681 4.617 4.598
USD INR Spot 3.545 3.535 3.545 4.079 3.513 3.593 3.545 3.485 3.437 3.525
Rate
Crude Prices 3.609 3.644 3.609 2.579 3.595 3.683 3.609 3.841 3.501 3.515
Reverse Repo 4.180 4.188 4.180 4.693 4.113 3.424 4.180 4.058 4.249 4.328
Amt
Repo Amount 1.440 1.439 1.440 1.206 1.439 1.380 1.440 1.501 1.448 1.405
The equations show that the slope of inflation with bond Return decreases gradually with
the bond maturity. That indicates a formation of a convex Return curve (considering only
the impact of inflation on Return). The t-test in the analysis proves the significance of all
the coefficients in the models. But, the higher slope of inflation shows that it has much
higher impact on the bond Return across all maturities than the other four market
variables. The slope declines with the maturity of the bond because inflation has much
higher impact on the short-term interest rate rather than that of the long-term ones.
Table: 6 – Regression Equations
11.58 + 0.182*Inflation + (-.132)*USD_INR_Spot + 0.006*Crude_Price +(-

Y1
0.001)*Reverse_Repo_Amt + .000*Repo_Amt
11.653 + 0.141*Inflation + (-0.131)*USD_INR_Spot + 0.008*Crude_Price +
Y2
0.000*Reverse_Repo_Amt + .001*Repo_Amt
11.58 + 0.182*Inflation + (-0.132)*USD_INR_Spot + 0.006*Crude_Price +
Y3
.ooo*Reverse_Repo_Amt + .000*Repo_Amt
8.843 + 0.117*Inflation + (-.073)*USD_INR_Spot + (-.019)*Crude_Price +
Y4
.000*Reverse_Repo_Amt + 5.391E-5*Repo_Amt
9.445 + 0.089*Inflation + (-.071)*USD_INR_Spot + .009*Crude_Price +
Y5
.000*Reverse_Repo_Amt + .000*Repo_Amt
7.960 + .067*Inflation + (-.037)*USD_INR_Spot + .011*Crude_Price +
Y6
Y7
Y8
9.140 + 0.044*Inflation + (-0.058)*USD_INR_Spot + 0.012*Crude_Price + (-
Y10
0.000)*Reverse_Repo_Amt + .000*Repo_Amt
Y11
USD INR exchange rate has high negative slopes with bond Return. But the slope
declines with the increase in bond maturity. This goes in sync with the previous
explanation that says that the exchange rate impacts the fund inflow to the country in a
negative manner. That reduces the interest rate and hence the bond Return. This impact is
more visible in case of short term bonds as per the regression equations.
GRAPHS depicting the variation of bonds of different maturities with the dependent
variables :
Crude oil price has positive slope with the bond Return. As explained before, this is due
to the fact that increase in oil price adds to inflation and hence, it indirectly increases the
bond Return. But, the regression equations also show that the slope is marginally lower in
case of short-term bonds than that of the long-term ones. Hence, on the basis of statistical
analysis, it can be concluded that crude oil price has more impact on the long-term bond
Returns than that of the short-term ones. A Comparative Analysis between a short-term
and long-term bond Return :
Following graphs explain in detail the movement of the Return curve with respect to the
independent factors considered in the analysis.
Short-term: 1 Year Bond Return
Though repo and reverse-repo balance has theoretical impact on the bond Return, the
statistical analysis didn’t find a consistent relationship between these factors. Regression
equations contain both positive and negative coefficients for the two factors. This
inconsistency shows that the impact of these two market variables on the bond Return
might be getting nullified due to the other major factors, which is not getting captured in
the regression equations. However, with this analysis it would be difficult to conclude the
impact of repo and reverse-repo on the bond Return.
The movements of the curves in the graphs show that inflation has more impact on the
Return of a short-term bond than that of a long-term one. This is for a simple fact that
inflation always has a short-term impact on the bond market (a part of literature review).
When inflation increases the bond value decreases for a short period of time. That has an
obvious positive impact on the Return as the price and Return of a bond are inversely
proportional to each other. Reverse repo amount is the cash balance that RBI has or the
money that Banks deposit with RBI. Graphs show that the reverse repo balance has high
negative correlation with the bond Return. By comparing the graph of the short-term
bond with that of the long-term it can be concluded that the slope of the reverse repo
factor with Return doesn’t change with maturity.
Conclusion and recommendations

The paper has tried to model a relation between the market variables and the bond
Returns. This has been done for the bonds of different maturities from 1 year to 10 years
and the relation has been captured by macro and micro market variables viz. inflation,
exchange rate, crude prices, repo and reverse repo which govern the cash balances with
RBI. This research has found some kind of relation between these chosen variables and
the bond Return of different maturities. While some of the factors have more correlation
with the bond prices, others are quite insignificant in affecting the Return.
The results of regression model also depicted that the bonds of different maturities
generally move together with any given variable i.e. any variable would affect the bond
price of shorter maturity same as that of longer maturity. It confirms also that the
changing fundamentals affect bond prices. The empirical results show also that the
movement in micro market variables like exchange rate volatility and the fluctuations in
liquidity - governed by repo and reverse repo - affect bond pricing. Some of the models
in form of regression equations presented in the paper seem to be potentially useful in
decision making or forecasting by investors, primary dealers, central bank (RBI) and
fiscal authorities.
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Article No.

STUDY OF VARIOUS FACTORS AFFECTING

Dr. Anurag Agnihotri

Table 1: Pearson Correlation of Bond return and Inflation

Pearson Bond Return

USD INR Spot - - - - - - - - -0.589 -0.564

Table 3 : Statistical result of bond returns

Table 4 : Auto correlation and bond return

Muti Bond Return

Table: 6 – Regression Equations

11.58 + 0.182Inflation + (-.132)USD_INR_Spot + 0.006*Crude_Price +(-

Conclusion and recommendations

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