Firming up of interest rates has implications for bond investors. Here are various strategies you can look at
In the recent monetary policy, the Reserve Bank of India (RBI) left the key interest rates in the country unchanged. However, elsewhere in the country the interest rates have started rising. Now, where is this happening? This is in the Indian bond markets.
Let us take the 10-year benchmark yield that is considered to be a good indicator of the Indian economic cycle. The 10-year government paper has been on a continuous upside for the last three months. The benchmark yield which was at a yield of 6.44% in August is now at a good 7.17%. So, why have long-term bond yields been rising?
Experts feel that yields have been rising due to the increase in inflation. Retail inflation in October 2017 touched a high of 3.58%. This is the highest in seven months. In fact, retail inflation has been on the upside since June 2017. In June, inflation was around 1.46%, the lowest since the start of 2012.
Are there any reasons why inflation is rising? It looks like inflation is rising because of rallying crude oil prices. Brent crude has been trading at over $54 for the past 3 months. This is the highest since 2015. Petrol prices in Delhi have gone up by more than 7.6% in the past year. As you might know, India is one of the largest importers of oil and any rise in oil prices will mean higher inflation for the country.
Coming back to our story, oil prices have led to higher inflation, which in turn has led to higher bond yields in India. The worst part is that the difference between short-term and long-term yields are quite high. The difference is over 100 basis points. For example, while 10-year benchmark yields have risen quite significantly, the three-month treasury yield has hardly moved three basis points. This means that the yield curve in the country is steepening.
The steep curve
There are two reasons why yield curve steepens. One is when inflation is rising (which is the situation in India) and another is strong economic growth. The latter might not be true as most experts expect fiscal slippages. Usually, the yield curve starts steepening at the end of an interest rate cycle.
Another reason why yields are rising is that of tightening liquidity. RBI manages liquidity through its Open Market Operations (OMO), that is, buying and selling of government securities. RBI recently cancelled its OMO, making it clear that it is not going to enhance liquidity. When liquidity tightens, bond yields need to move up. Does this mean there won’t be any more rate cuts? Maybe. In fact, many experts are predicting that the interest rates might start rising in another year or so.
So, what does all this mean if you are a bond investor or a debt mutual fund investor?
What to do?
Long-term bonds might not be great investments in the coming days. As long as interest rates were falling, long-term bonds were doing well. Now that things seem to be slowing down and an upward interest rate cycle seems to be on the horizon, long-term bonds might turn volatile. The returns from long-term securities will also moderate. If you are one who doesn’t like taking much of risks, it is better to move to short-term bonds. The same is true for debt mutual fund investors.
If you have long-term goals to which your long-term debt funds are linked, it is best to leave them alone. However, if you are one who doesn’t like volatility in your debt investments, it is best to move on to short duration funds. You can consider liquid, ultra short-term and shorter duration funds depending on the time horizon of your goals. Do keep watching the bond market for the right signals.