Time to lock in to higher interest, longer-maturity bonds

By Arjun Parthasarathy

Interest rate revisions are keeping bank fixed deposit rates high. But this also means the stage is being set for rates to fall as the economy slows down.

Investors will thus do well to extend the maturities of their fixed income portfolios. If you are predominantly invested in fixed deposits, FMPs (fixed maturity plans), post office savings schemes or public provident funds (PPF), you run a big reinvestment risk if interest rates fall from current levels.

Reinvestment risk is when you are invested in a one-year fixed deposit yielding 10% per annum and upon maturity you open a new one-year fixed deposit at 6% per annum. What was earning you 10% on your capital last year will earn you only 6% this year because interest rates have fallen.

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[caption id=“attachment_29297” align=“alignleft” width=“380” caption=“By investing directly in government and corporate bonds with maturities of five years e you can benefit from yields falling and minimise reinvestment risk. Image by David Dugdale/Flickr”]  [/caption]

In the meanwhile, yields on government and corporate bonds would have fallen due to a fall in interest rates. The holder of a long maturity bond benefits in two ways as yields fall. The first is through capital gains, as bond prices go up when yields fall, and the second is the coupon, as the holder receives higher interest for a longer period despite interest rates going down.

Hence by extending the maturity of your fixed income portfolio by investing directly in government and corporate bonds with maturities of five years and above you can benefit from yields falling and minimise reinvestment risk.

In number terms, if yields fall by 1%, a 10-year government bond price will go up approximately by Rs 7 (on a Rs 100 face value). Given that the government bond will pay a coupon of 8.20% (if a new 10-year bond is issued), the total gain in one year is price appreciation plus coupon rate, which is Rs 7 + Rs 8.2 = Rs 15.2, or 15.2% return on an investment of Rs 100 in one year’s time.

The risk, however, is that yields rise by 1%, making you incur a capital loss of Rs 7 and bringing down returns to 1.2% (- Rs 7 + Rs 8.2). If yields rise by 1%, you will actually have better levels to reinvest next year. The bottomline is when yields are falling it is better off extending portfolio maturities and when yields are rising it is better off reducing portfolio maturities.

The question you should be asking yourself now is whether yields are going to fall or rise in the next one year. The answer is easy to arrive at if one goes by the RBI’s signal of raising interest rates to bring down inflation. The RBI raised the benchmark repo rate by 25 basis points (100 basis points equal 1%) on June 16, citing rising inflationary pressures in the economy.

The RBI has also guided the markets for a 25bps hike in the repo rate in its July policy review meet. The RBI’s actions suggest that interest rates will go higher and bond yields will also go higher. If this is true you are better off being invested in fixed deposits or FMPs.

However, markets behave in a very different way. If the market believes that if the RBI, by raising interest rates to bring down inflation, will actually be successful, it (the market) will bring down bond yields. The reason the market will give in taking down bond yields is that because of rate increases by the RBI, inflation will come down as demand slows down and economic growth suffers.

This scenario is more likely to take place than the other scenario where inflation will continue to go higher and interest rates also follow suit.

The current economic environment is actually deflationary in nature. Domestic growth is expected to slow down on the back of high inflation and rising interest rates. The Reserve Bank’s GDP growth forecast for fiscal 2011-12 is around 8%, down from 8.5% seen in 2010-11.

GDP growth is more likely to come in below 8% as signs of economic slowdown in the form of lower industrial production growth (IIP) numbers and falling bank credit growth emerge. IIP growth came in at 6.3% for April 2011, a contraction of 1% month on month. Credit growth is down from 23% to 21% levels over the past six months due to rising interest rates.

Weak equity markets are hampering capital raising for investment. The broad market indices, the Sensex and Nifty, are down 10% from mid-April highs. High interest rates, slow investment growth and weak market sentiments will bring down demand in the economy, leading to inflation coming off.

Global growth too is expected to weaken as central banks from China to Brazil are raising interest rates to bring down inflation and cool down growth. The US economy is facing high unemployment while the eurozone is facing a sharp slowdown in countries such as Greece, Ireland and Portugal due to debt default issues. Global growth slowdown will keep commodity prices in check, leading to a fall in inflation expectations.