A small increase in bond yields despite a 25-basis-point cut in repo rate by Reserve Bank of India (RBI) has confused many novice fixed income investors.
The textbook of bond investing says, with a fall in policy rates, the interest rates in the economy go down. The move in contradictory direction makes many revisit their investment premises in fixed income space. Experts, however, rule out any erratic movement in the bond markets and instead advise to stick to one’s financial goals while investing.
How the stage is set
Before we get into how an investor should be allocating his money, let’s understand the broad picture. 25 basis point reduction in repo rate by RBI on April 4 came after a 25 basis points cut announced on February 6. Though the action was on expected lines, the fixed income market did not like the commentary.
The 10-year benchmark yield closed at 7.38 percent on April 9. A point to note is on December 31, 2018 the yield was at 7.37 percent that means that despite two rate cuts by RBI, the long term rates are flat—after moving in a range of 7.22 percent – 7.69 percent.
After the ILFS saga, the flight to safety has ensured that investors stick to high-quality bonds. AAA rated bonds that were available at 8.5 percent-8.7 percent yields have seen fall in yields by as much as 50 basis points as investors have flocked to buy them.
For example, L&T Finance is offering 9 percent interest on non-convertible debentures for five-year tenure with AAA rating in its second tranche that opened on April 8. The same issuer was offering 9.25 percent for similar NCD issue that closed on March 20—a quarter percentage drop over a couple of months.
The drop in yield makes the investment opportunity in high-quality bonds less attractive as compared to what it was at the beginning of 2019.
Though the high-quality bonds are in demand, AA rated papers are still in woods. Not many investors are willing to look at them. The yields are in the range of 9.5 percent – 10 percent. Though the yields make it an attractive proposition, do not ignore the elevated risks they come with as compared to their AAA rated counterparts.
The three observations mentioned above pertaining to long-term rates, yields on AA bonds and yields on quality papers may see seemingly disconnected factors from each other. However, they are outcomes of investors’ action.
The volatility in currency and crude has been playing on the minds of investors and is reflected in 10-year rates. The commentary of RBI further made investors wary of the macro risks such as the possibility of inflation arising out of crude oil price hike and below normal monsoon.
“RBI’s open market operations may buy less amount of government securities this financial year compared to previous year, which may ensure that the benchmark 10-year yield may remain in the range of 7.25 percent to 7.5 percent and won’t go down much,” says Joydeep Sen, Founder of Mumbai based wiseinvestor.in.
Sen further points to a higher rate of interest demanded by investors for investments in NBFC compared to what was being offered prior to ILFS debacle.
While these two options are exposed to relatively higher risk the money is coming into what is remaining – the quality papers (with AAA rating) with maturities less than three years.
Where to invest
Uncertainty over the fiscal deficit situation, economic growth and crude oil price movement makes long term gilt funds a risky bet for most investors. Investors have to strike a balance between the tenure and the credit quality of the instruments they invest in.
Though credit risk funds do look good, investors should not go overboard. “One should have around 60 percent to 80 percent money in high-quality bonds and the remaining can be invested in credit risk funds that invest in AA-rated papers and below,” says Ashish Shanker, head – investment advisory, Motilal Oswal Private Wealth Management.
If you are keen on playing it safe, it is better to invest in high-quality bonds or bond funds investing in high-quality instruments. Also, it is better to avoid duration risk. Though some dynamic bond funds are doing good, they come with very high fund manager risk as the fund manager takes duration and credit risk depending upon his view of financial markets.
“Investors would be better off investing in short duration bond funds that invest in bonds that mature in one to three years time frame,” says R Sivakumar, Head-Fixed Income, Axis Mutual Fund. Gautam Kalia, Head-Investment Products, Sharekhan also advises on similar lines.
If an investor remains invested in a bond fund for three years then the gains realised are treated as long term capital gains and taxed at a 20 percent rate of tax post indexation.
While bond fund investors will try to adjust their allocations to a few investment options, the bond investors and fixed deposit investors will be spoiled for choice.
The first fortnight of the financial year that began on April 1, saw five issues of NCD. Market participants are expecting more issuances going forward. Ashish Shanker says, “Investors should look at the bonds issued by select NBFC with a good track record. Current situation of scarce liquidity for NBFCs is offering some good investment opportunities. Being selective will help to lock in good rates.”
Fixed deposit investors, however, have to choose the right issuers and the right time frames to earn steady income. Feroze Azeez, Deputy CEO, Anand Rathi Private Wealth Management expects the bank fixed deposit rates to go down soon in line with RBI rate action and hence is in favour of locking in the rates wherever required.
Ashish Shanker, on the other hand, says that the rates may remain stable for some time before they go down, as the bank credit growth is higher than the bank deposit growth.
In that case, Investors may look at fixed deposits of some NBFC that offer good track record. Then there are some opportunities in the form of the right choice of issuer with a similar level of risk. For example, it makes sense to invest in 33 months fixed deposit of HDFC limited that offers 8.19 percent over a similar fixed deposit by HDFC Bank that offers 7.25 percent.
Investors should also take into account their liquidity needs and financial goals before signing above the dotted line.