What investors should do when interest rates fall

Interest rates are likely to fall next year with the Reserve Bank of India likely to cut the benchmark policy rate , the repo rate, on the back of falling inflation and slowing economic growth.

Fixed-income investors who are positioned for a rising interest rate environment should now look to position themselves for a falling interest rate environment. How does one position fixed income portfolios for expected lower interest rates down the line?

The two basic principles of fixed income ar:

a) Prices of fixed income securities go up when interest rates fall and

b) the longer the maturity of a fixed-income instrument, the higher the rise in price for a one basis point fall in interest rates.

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Simply put, investors holding fixed-income securities will benefit from the rise in prices when interest rates fall, and investors holding fixed-income securities that mature over a period of time will gain more than investors holding fixed-income securities that matures in the near future.

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In a falling interest rate environment, investors will do well to invest in fixed-income securities that have maturities of two years or more.

Investors aiming for higher returns should invest in fixed-income securities that have maturities of five years or more.

Given that investing directly in fixed-income securities is not easy in India, mutual fund schemes that invest in fixed-income securities that have longer maturities is the best choice for investors.

Mutual funds have many products in the fixed-income space, including short-term debt funds and long-term debt funds.

Short-term debt funds invest in fixed-income securities with maturities of less than five years, while long-term debt funds can invest in fixed-income securities that carry maturities of even 30 years.

Obviously, the choice for the investor in a falling interest rate environment is long-term funds.

What will be the expected return of a short-term fund and a long term fund over a one year period when interest rates fall by 100 basis points or 1 percent?

The expected total return indicated is for a one-year holding period.

Investors gain from higher coupon plus capital gain when interest rates fall. The risk is also easy to calculate. Turn the capital gains to a negative sign and the returns given a 100 basis point rise in interest rates will show up.

Table 1. Expected return by investing in short term and long term funds

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The returns given in Table 1 are only indicative and it depends on many factors including portfolio positioning and portfolio flows.

A short-term fund will have a mix of securities with varying maturities and that mix will impact yields.

Shift in yield curves, shifts in credit spreads etc. will impact the performance of the portfolio and investors may get lower or higher returns on the back of these shifts.

Flows also impact the portfolio performance, as the portfolio is not static. If more investors come in to the fund and yields drop, the portfolio will be invested at lower levels of yields and this will impact returns.

If money comes in and goes out quickly when rates are not favorable, then the portfolio will even incur a capital loss.

Investors have to be aware of all these factors before investing in short-term or long-term funds. However, given the lack of choice, it is best to be invested in either short-term or long-term funds in a falling interest rate environment.

Long-term funds are better for investors as they are cleaner than short-term funds.

Long-term funds have a mix of investments in government bonds and corporate bonds and are usually invested in benchmark AAA papers. It is easier to judge the performance of these funds.

Short-term funds, on the other hand, have a mix of papers including money market securities, and given that corporate money tends to flow into these funds, the portfolios are determined by what a large corporate wants rather than what the fund manager believes in.

Expense ratios, too, are similar for short-term and long-term funds, and if interest rates fall, returns are much better in long-term funds despite high expense ratios.

Arjun Parthasarathy is the editor of www.investorsareidiots.com, a website for investors.