Interest rates

money-making ideas: investing in debt in times of rising interest rates; park 10 to 20% cash

In the fourth quarter of 2021, the Federal Reserve signaled its intention to control the inflation spiral in the United States by canceling its stimulus program and raising interest rates. In March 2022, the US Fed raised rates for the first time since 2018 by 25 basis points (or 0.25%).

Meanwhile, the RBI’s Monetary Policy Committee (MPC) continued to have a favorable view on inflation, expecting it to decline, and maintained a dovish stance during its February meetings. and April.

March inflation (based on CPI) in India came in at 6.95%, indicating a spike in food inflation accompanied by a rise in fuel and raw material inflation in due to the persistent rise in world prices of raw materials and foodstuffs due to the Russian-Ukrainian conflict.

In an off-cycle move, on May 4, the RBI announced a 40 basis point (0.4%) increase in the benchmark repo rate and a 50 basis point (0.5%) increase in the repo ratio. cash reserve (or CRR).

The US Fed also raised rates by 50 basis points on May 5. Indian bond markets reacted quickly, with the benchmark 10-year government bond yield jumping 30 basis points to 7.4%.

There is no clear indication from the RBI on how much it will raise rates in the future. Market participants generally expect him to hike rates by at least 80 basis points to 100 basis points, bringing the repo rate back to its pre-pandemic level of around 5.25 to 5 .5%.

The magnitude and pace of increases will depend on movements in global commodity prices and domestic inflation over the coming months.

Clearly, the interest rate cycle has moved from an easy or downtrend to a tighter one where interest rates are expected to rise.

How should bond investors react to this change in cycle? Is it necessary to restructure the portfolios?

Debt plays an important role in a portfolio. It can act as a cushion during periods of significant market volatility, hold or fall significantly less than stocks (eg 2008-09, early 2020, etc.), generate steady income and provide investment opportunities attractive, especially when real inflation (or inflation-adjusted) interest rates are above long-term averages.

Bond yields consist of two components: the coupon or interest paid by the bond and any capital appreciation or depreciation based on its price movements.

Bond prices and interest rates are like opposite sides of a seesaw, when one side goes up, the other goes down. Similarly, when interest rates rise, bond prices fall and vice versa.

And the extent to which bond prices fluctuate in response to movements in interest rates depends on the residual term (i.e. the number of years remaining for the bond to mature) or the duration of the bond. The longer the duration, the greater the fluctuation in bond prices.

Also, as the duration of a bond or government security increases, one would expect to generate a higher yield or coupon due to higher uncertainty or risk associated with holding bonds with a longer duration.

The yield or coupon available for each bond term is called the “yield curve” and the difference between the yields of different bond terms is the “duration difference”.

For example, the 1-year treasury note (or treasury note) issued by the Indian government yields around 5.50% and the 10-year government note (or G-Sec) yields 7.40%.

As a result, the duration difference between the 1-year T-Bill and the 10-year G-Sec is 1.90%, which is the extra yield for holding a longer-term bond. Historically, this spread has averaged around 100 to 150 basis points (or 1% to 1.5%), indicating that the current spread is attractive.

As widely expected, if the RBI continues to raise rates, it is likely that yields on short-term bonds would rise more than those on longer-term bonds, which have already risen in anticipation of further rate hikes.

As a bond investor, one can ladder investments (vs. capital investments) in fixed deposits or individual bonds at current rates, as these could rise further.

For investors in debt mutual funds with a horizon of 3 years and more, approximately 40 to 50 percent of the corpus can be invested in funds with a portfolio duration of 1 to 3 years such as bank funds and PSU and corporate bond funds, where the impact of interest rate increases on overall return would be limited due to low duration.

About 10-20% can be invested in liquid or very short-term funds with a term of less than 1 year; the yields of these funds would start to rise now and the impact of rate increases on the prices of the underlying bonds and the overall return would be minimal.

As yields from bank debt and PSU or credit risk funds increase, one could shift investments from liquid funds to these categories.

Given the attractive spreads over the medium to long duration of the G-Sec yield curve (5-10 years), one could invest around 25-35% in medium to long duration debt funds or dynamic bond funds, especially those holding G-Sec.

One can also consider passive or roll-down index funds that invest in G-Secs, say with a residual maturity of 5-7 years, and hold them to maturity.

Due to higher duration spreads, these securities trade at attractive yields, offering better regularization, and working capital expense ratios are lower than actively managed funds.

The recent spike in volatility in stock and bond markets can be disconcerting. Remember that markets are cyclical in nature and periods of strong performance tend to be followed by periods of underperformance or poor performance. As an investor, you need to focus on your goals, stick to your asset allocation plan, and avoid making decisions driven by short-term trends.