Long duration bond funds are poised to benefit from a dip in interest rates
After many troubled months of above-average interest rates in the Indian economy, investors may soon gain some respite in the form of reduced interest rates. With lower interest rates, long-duration bond fund-holders can gain in the next few years as the dip in interest rates pushes up the prices of long-duration bonds.
Long-duration bond fund holders are in a sweet spot. The present macroeconomic situation has tilted the scales in their favour as interest rates appear all set to dip. The Reserve Bank of India has been holding interest rates at higher levels for some time now, and this provides investors with the much-needed time to settle into longer duration bond funds.
The 10-year government securities (G-sec) yield is at a peak, currently hovering around 8.36%. The liquidity situation has improved in the recent past. As the RBI keeps the rates tight, the real rate of return in the hands of the investors is getting better. This is expected to drive more investors into financial assets in the coming months, which could then pump liquidity into the system.
In turn, this could have a beneficial effect of lower bond yields in the months ahead. In the past, whenever 10-year G-sec yields held above the long-term average, we have seen drop in yields in the next 18 months. To top it all, the current account deficit has considerably improved in the past few quarters and India's balance of payments has swung back to a surplus during the October-December 2013 quarter, aided by strong flows in debt and equity.
A better current account deficit helps external trade balances and boosts domestic liquidity. Long-duration bond holders can also benefit from falling inflation, which has been easing of late. In September 2014, the consumer price inflation (CPI) came in at a softer 6.46%, down from 7.7% in the preceding month.
The RBI has shifted its inflation-monitoring benchmark to the CPI, with a target of 6% by January 2016 for this indicator. Signs of lower inflation levels could see a cut in the interest rate sooner or later. Longer duration bond fund holders can stand to benefit when the interest rate comes down. As the interest rates fall, bond prices begin to accelerate. In fact, many different maturities of bond prices tend to appreciate in value with falling rates, but the largest gainers are longer dated bonds, those with more than five years' maturity.
Hence, in the present environment, investors could do well to add duration to their bond fund holdings. Duration is in essence the exposure of bond funds to longer maturity fixed-income instruments. Lengthening the duration of their holdings in a bond fund improves the prospects of a bond fund, and positions such holdings to benefit from any fall in rates. Bond funds generally come with varying maturities, from ultra-short term to medium and long term. Gains accrue to investors in short-term funds. In long-term funds, gains are made through price increases in debt holdings when rates decrease.
Hence, investors could begin to increase the exposure to these long-duration funds over time. A short term bond fund which invests in securities that mature in about a year or so, could still gain from falling interest rates, but the gains are not as much as a fund with a longer duration. However, longer duration bond funds tend to be more volatile in the short term depending on interest rate movements and anticipation of policy rates.
Further, if the RBI holds the rates at elevated levels for some more time, the gains in long-duration bond funds could take some time to be visible. However, by holding to a longer term horizon while going in for longer duration debt funds, say, of two to three years, while ignoring short-term volatility, the scales tilt in favour of the long-term bond investor.
This article was published in ET Wealth on 3rd November 2014 on page 8.