Debt investing in times of rising interest rates

Jun 07, 2022

In Q4 2021, the Federal Reserve signaled its intent to control spiraling inflation in the U.S. by unwinding its stimulus program and raising interest rates. In March 2022, the Fed increased rates for the first time since 2018 by 25 bps (or 0.25%).

Meanwhile, the Reserve Bank of India's Monetary Policy Committee (MPC) continued to hold a benign view on inflation, expecting it to subside and maintained an accommodative stance in its February and April meetings. March inflation (based on Consumer Price Index, or CPI) in India printed at 6.95% indicating a spike in food inflation accompanied by higher fuel and commodity inflation on the back of persistently elevated global commodity and food prices driven by the Russia-Ukraine conflict.

In an off-cycle move on May 4, 2022, the RBI announced a 40 bps (0.4%) increase in the benchmark repo rate and a 50bps (0.5%) hike in the Cash Reserve Ratio (CRR). The Fed also increased rates further by 50 bps on May 5, 2022. Indian bond markets reacted swiftly with the 10-year Government security benchmark yield jumping by 30 bps to 7.4%.

There is no clear guidance from RBI on the extent to which it will raise rates going ahead. Market participants broadly expect it to hike rates by at least another 80 bps to 100 bps taking the repo rate to its pre-pandemic level of around 5.25%-5.5%. The magnitude and pace of increases will be driven by movements in global commodity prices and domestic inflation prints over the next few months. Clearly, the interest rate cycle has shifted from being easy or downward trending to tightening where interest rates are expected to move up.

How should Debt investors react to this shift in the cycle and is there a need to restructure portfolios?  

Debt plays an important role in a portfolio. It can act as a cushion in periods of significant market volatility, holding steady or falling substantially lesser than equity (e.g., 2008-09, early 2020, etc.), generate regular income, and provide attractive investment opportunities, particularly when real (or inflation-adjusted) interest rates are above long-term averages.

Returns from bonds comprise two components – 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 the opposite sides of a seesaw, when one side goes up the other goes down. Similarly, when interest rates go up, bond prices go down and vice-versa. And the extent to which bond prices fluctuate in response to interest rate movements depends on the residual maturity (i.e., the number of years remaining for the bond to mature) or duration of the bond. The higher the duration, the greater the fluctuation in bond prices.

Further, as the tenor of a bond or government security increases one would expect to generate a higher yield or coupon due to higher uncertainty or risk in holding longer tenor bonds. The yield or coupon available for each tenor of bonds is referred to as the ‘yield curve’ and the difference between yields for various bond tenors is the ‘term spread’. For instance, the 1-year Treasury bill (or T-bill) issued by the Government of India yields around 5.50% and the 10-year Government security (or G-Sec) yields 7.40%. Accordingly, the term spread between the 1-year T-bill and 10-year G-Sec is 1.90%, which is the additional yield for holding a longer tenor bond. Historically, this spread has averaged around 100bps-150bps (or 1%-1.5%), indicating that the current spread is attractive.

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

As a debt investor, one can stagger their investments (vis-à-vis investing in lumpsum) into fixed deposits or individual bonds at current rates as these might go up further. For investors in debt mutual funds with a horizon of 3 years and above, around 40-50% of the corpus can be invested in funds with a portfolio duration of 1 to 3 years such as Banking & PSU Funds and Corporate bond funds, where the impact of interest rate increases on overall return would be limited due to the low duration. Around 10%-20% can be parked in Liquid or Ultra-Short Term Funds with a duration of less than 1-year; yields on these funds would start rising now and the impact of rate increases on underlying bond prices and overall return would be minimal. As yields on Banking & PSU debt or Credit Risk Funds increase, one could move the liquid fund investments to these categories.

Given the attractive spreads in the medium to long duration of the G-Sec yield curve (5 to 10 years), one could invest around 25%-35% in medium to long duration debt funds or dynamic bond funds, particularly those holding G-Secs. One can also consider passive or roll-down index funds which invest in G-Secs, say with a residual maturity of 5 to 7 years, and hold them till maturity. Due to higher term spreads, these securities are trading at attractive yields, providing better accrual, and expense ratios for roll-down funds are lower than actively managed funds.

The recent spike in volatility in equity and bond markets can be unnerving. Remember markets are cyclical by nature and periods of strong performance would tend to be followed by periods of under or low performance. As an investor one needs to focus on their goals, stick to their asset allocation plan, and avoid making decisions driven by short term trends.

The article was first published in Economic Times. 
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