Interest rate expectations are quietly getting reset, and this asset class is becoming attractive.
While the equity markets have garnered a lot of attention since the US-Iran war began, it is important that investors need to note happenings on the debt side too. Interest rate expectations are quietly getting reset, and this asset class is becoming attractive.
Here are answers to top questions on your minds on debt investing today :
When The Stock Markets Fell Due To War, I Saw Bond Yields Rising. Why Did Stocks And Bonds Move In The Opposite Direction?
They did not.
Fear is the driving factor for markets during a crisis and both stocks and bonds reacted negatively to the developments last month. Amid disruptions caused by war, stock prices fell on flight to safer avenues (in terms of asset classes or geographies) / on earnings growth concerns. Like stock prices, bond prices dropped too.
Typically, a war raises concerns that inflation could go up (due to higher energy/commodity prices and supply disruptions) and that the government might have to borrow more to rebuild the economy. To combat inflation and attract fresh borrowings, interest rates could rise. When newer bond issues are expected to have higher interest rates, existing bonds at the prevailing interest rates become unattractive. Hence, investors sell these bonds resulting in a fall in their prices.
When bond prices fall, their yields rise. Letās take a simplistic example. Assume a bond with Rs 100 face value with an interest rate of 6 %. If market price = face value, then the yield will also be 6%. If the market price falls to say Rs 97, the yield will move up to 6.19 %. This is what played out in bonds in the ongoing war.
Apply the same logic to stock earnings and you will understand better – when markets fall, earnings yield rises. For example, the Nifty PE (trailing) during September 2024 market peak was 24 times. Earnings yield (calculated as 1/PE ie 1 / 24) stood at 4.17 %. The market dip brought down the Nifty PE to 20 times in March. Consequently, earnings yield moved up to 5% ( ie 1/20).
As a practice, prices of stocks and yields of bonds are more widely tracked. Hence, though they appeared to be moving in opposite directions, in reality, they didnāt.
I Thought Gilt Funds Are A Very Safe Choice Since They Have Only Government Securities In Their Portfolio. Why Did Many Of Them Show Negative Returns In The Short-Term, Following The Conflict?
It has happened due to āinterest rate riskā playing out.
Safety in bond investing should be viewed in the light of two risk factors: interest rate risk and credit risk.
Interest rate risk plays out when older bonds become unattractive and lose value because of an expectation of rise in interest rates. All bonds, including government securities are subject to this risk. Yields on the 10- year government securities (widely used as benchmark to track bond yield movement) moved from 6.6 % just as the war began to 7.1% at its peak in early April before retreating to 6.9 % now. Many gilt funds hold bonds with longer durations. The fall in prices of these bonds (due to the rise in yields) reflect in their NAVs (net asset value) and the negative return in the last one month. Funds in a similar category – gilt funds with constant duration of 10 years – too faced a fall in NAVs in the last month for the same reasons.
You Are Talking Only About āExpectationsā So Far. Are Interest Rates Really Moving Up Because Of The War?
Directionally, it appears so, though we are still in wait and watch mode.
Usually, the RBI targets inflation to be in the 4-6 % range. Presently, it does not expect inflation to exceed this range in 2026-27. This implies that interest rates may not go up in a hurry. But if oil prices stay higher for longer, supply side constraints for industries (crude derivatives, gas, etc.) remain even after the war and a below-normal monsoon pushes up food prices, inflation may move beyond the comfort zone, forcing interest rate hikes.
From another perspective, foreign flows into Indian debt markets may be needed to combat higher dollar outflows (to pay for costlier oil imports, for instance) and stop depreciation in the rupee. A hike in interest rates is what will attract these flows.
The coming months will give us more clarity on the interest rate trajectory.
Considering Todayās Scenario, What Are The Debt Fund Categories I Can Invest In?
Choose funds which hold shorter duration bonds as they are less sensitive to interest rate changes. Ultra-short, low duration, money market and short-duration funds are some of the categories you can consider. They invest in instruments that have maturity of up to 3 years. You can continue to use liquid funds as a substitute to keeping your money in an SB account and to execute your STPs.
Another promising category today is floating rate funds. These funds invest in bonds whose interest rates are reset in line with the market rates. This approach is beneficial in a scenario where interest rates are expected to go up.
If you have already invested in gilt funds with a long-term perspective (during which few interest rate cycles will run their course), you can continue to hold it. But if you have parked it for the short-term, it is best to exit as their NAVs will be subject to high volatility now. The best time to invest afresh in these funds is when interest rates are peaking and the fund returns are in the deep red. There is still time for this to play out.
My Friends Suggest Bonds Which Give Double Digit Returns. Can I Invest In Them?
Best avoided.
If āinterest rate riskā affects all bonds, credit riskā affects only corporate bonds as government securities enjoy sovereign guarantee. The credit risk gradually moves up as the credit ratings of these bonds move below AAA. Usually, the ones with lower ratings give attractive interest rates (in a bid to compensate for the risk you are taking).
Then there is āliquidity riskā too for corporate bonds. If your bond is thinly traded or unlisted, finding a buyer when you want to sell and at the price you want to sell, may be difficult (even if you are going through an online bond platform).
These risks amplify in a situation where there is an economic slowdown (likely in a high inflation ā interest rate environment) and when there is pressure on margins and earnings for the company issuing the bond. During such times, the risk that bonds with low credit ratings may not be able to pay interest on the bonds or repay the principal is high.
What About Corporate Bond Funds? Are They A Better Choice?
Yes.
Corporate bond funds are mandated to invest at least 80 % of their portfolio in bonds rated AA+ and above. This helps in diversification as well as in keeping a check on credit risk. Go for funds with lower duration to avoid interest rate risk.
Today AAA rated corporate bonds of duration 1- 3 years sport over 7% returns, offering about 90 to 120 basis points higher than government securities of similar tenure. This is much higher than the 60 -65 / 75-80 basis points difference (called spread) seen a year ago and six months ago, respectively, making it a good time to invest.
I Donāt Want Fds Or Debt Funds Because Interest/Gains Are Taxed At Slab Rates. Arenāt There More Tax-Efficient Parking Grounds For My Short-Term Funds?
If you are looking to park money for shorter periods of up to three years, and want favourable taxation – arbitrage funds, equity savings funds and dynamic asset allocation funds can be good choices. To qualify for equity fund taxation, they maintain 65 % equity exposure through a combination of unhedged equities, arbitrage/ derivatives. The rest is invested in debt.
If Equity Markets Are Attractive Today, Why Invest In Debt ? Canāt I Be 100% In Equites?
Market presented bigger opportunities when it was 12-15 per cent down from the peak in March. Now that it has rebound, there is need to put in money selectively in pockets which will benefit from the changed macro-economic situation and in segments where valuations are conducive.
Whether you can be 100 % in equities, depends on your risk profile, life stage as well as time to your goal. If you are young and are saving for medium to long-term goals like down payment for your house or retirement, you can 100 % be invested in equities. If you have a lower risk appetite and/or are following an asset allocation plan, then setting aside a portion for investing in debt becomes necessary. Similarly, when you are close to your goal, moving the corpus from equity to debt will help you preserve the gains.
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