Understand fixed income investing
December 2011 inflation has fallen to 7.47% from levels of 9.11% seen in November 2011. The fall in inflation levels coincide with a downward revision of GDP growth forecast for the Indian Economy. The economy is expected to grow around 7% levels in fiscal 2011-12 against initial government estimates of 9%. The fall in inflation coupled with slowing economic growth will lead to the RBI reducing policy rates in calendar year 2012. The benchmark policy rate the Repo rate is at 8.5% and the CRR (Cash Reserve Ratio) is at 6% and RBI will bring down the repo rate and CRR to boost growth in the economy.
RBI reducing interest rates in the economy can bring down interest rates across fixed income investment classes. Government bond yields and corporate bond yields will fall, interest rates of fixed deposits will fall and returns on liquid funds and FMPs (Fixed Maturity Plans) will also trend down. The yields on government bonds and corporate bonds have already fallen by 50bps on expectations of rate cuts.
Investors should now review their fixed income investments as RBI shifts its policy stance from controlling inflation expectations to bringing about conditions for economic growth. Investors wanting capital gains on expectations of interest rates falling should look to invest in fixed income schemes of mutual funds, as it is the most convenient vehicle for gaining exposure to government and corporate bonds. Mutual fund schemes that invest in longer maturity government and corporate bonds are typically classified as long term gilt funds or long term income funds.
Long term gilt and income funds invest in government and corporate bonds with maturities ranging from five to thirty years, depending on the view of the fund manager. The price of longer dated bonds rise more than that of the price of shorter dated bonds when interest rates fall and vice versa. Capital gains will be higher on gilt and income funds when interest rates fall. The investment time period in such funds should be at least one year and investors should monitor the interest rate conditions in the economy carefully. If there is a change in sentiment on interest rates, investors will see volatility of returns on their investments.
Short term gilt and income funds invest in government and corporate bonds of less than five years of maturity. Capital gains will be lower in such funds and volatility of returns will also be lower if interest rate sentiments change.
Investors not willing to take volatility risk on their fixed income investments can play it safe by locking on to interest rates by investing in fixed deposits with longer maturity period or longer maturity FMP’s. Investors will then continue to earn high interest even though interest rates are falling in the economy.
Investors should be aware of interest rate risk, credit risk and liquidity risk on their fixed income investments. Interest rates falling fast and staying low will catch investors who have not invested in capital gain products off guard. For example if interest rates on a one year fixed deposit is 9.5% and interest rates fall, the reinvestment of money when the deposit matures could be as low as 6.5%, a clean 3% drop in rates. Interest rate risk works the other way too if interest rates rise and capital gain products give negative or very low returns due to rise in interest rates.
Credit risk is the risk of default or risk of the credit quality of the issuer falling. On a default the investor will not get back capital while on a falling credit quality the investor can suffer capital loss if price of the corporate bond goes down due to credit concerns. On the upside, if the credit quality of an issuer improves, the investor will gain as the price of the corporate bond rises due to better credit perception.
Liquidity risk is the risk of trading volumes drying up in government bonds or corporate bonds. Government bonds carry less liquidity risk as the RBI will lend against government bonds while corporate bonds carry more credit risk as there is no stop gap lender if corporate bond trading volumes dry up. The higher the credit quality in corporate bonds the lower the liquidity risk. Investors can suffer from liquidity risk if there is sudden selling in the fixed income market and prices crash due to more sellers than buyers.