The fixed income party’s not over, only the venue has shifted

Highlights

• The RBI’s decision to pause rate hikes is seeing some market players call a peak in the interest rate cycle


• Equity bulls are pencilling a rally on hopes of money turning cheaper, while some fixed income investors are worrying that the era of higher interest rates has peaked


• But neither is right. The RBI has only signalled a pause and not a pivot. And, while certain instruments in the fixed income camp may fall out of favour, there’s one avenue open for investors to profit from


• The party’s only shifted to a different venue in fixed income city

Shaktikanta Das, the Reserve Bank of India’s governor, announced a pause in interest rate hikes on 6th April 2023. And some market players are already calling a peak in the interest rate cycle. There is joy in the camp of equity bulls as they expect the stock market to rally on this news. But, there seems to be pessimism in the camp of fixed income investors as they believe higher yields have run into a dead end sooner than they thought.

Both camps seem to be jumping the gun

The RBI governor has clearly said that this is only a pause and not an end to rate hikes. He will be watching if central bankers in the West hike rates further. In that case we will see another round of hikes in India due to cash carry considerations. I wrote about these compulsions in my previous article here.

A sagacious trader/investor plans for contingencies like expectations not being fulfilled in the market or even events going against expectations. Therefore, is the party over for a fixed income investor?

While the venue may have changed, smart money is already putting alternative blueprints in place.

If coupon rates have indeed peaked out, fixed income investors will get bigger bang for their buck as another set of investments will possibly give them double-digit returns with negligible to zero credit default risk.

I am referring to gilt funds. These mutual funds are required under securities laws in India to invest a minimum of 80 percent (or higher) of their corpus in central and state government securities. A tiny component may be invested in highly rated corporate bonds or other investments to provide higher αlpha (absolute returns) in the fund. The skew of these funds towards G-Secs provides safety.

Since bond prices start rising as interest rates peak out or fall, there is capital appreciation for an investor as gilt mutual funds’ NAVs (net asset value) rise. Add the bond’s interest distribution and you can get up to double digit percentage returns as long as an investor has timed the entry precisely.

Other factors that an investor must note before choosing the right gilt fund

Interest Rate Cycle: Timing is everything in gilt fund investments. You buy only when there is evidence that rates have peaked or are certainly near the peak. Mistimed investments could mean the NAV may fall after you buy, thereby impacting yields adversely. In that case you will have to wait for the next rate cycle to peak before you get desired results.

Expense Ratio: Gilt funds are typically more expensive in terms of managing fees as compared to index funds. Though SEBI has capped the expense ratio at 2.25 percent, competitive forces in the markets ensure a somewhat lower ratio. The lower the expense ratio, the higher the take home profits for the investor, all other factors remaining equal.

Bond Convexity: Bond prices are inversely correlated with interest rates. If rates rise, bond prices fall and vice versa. This movement in bond prices is called convexity. But that is where the one-size-fits-all similarity ends. Long tenor bonds (long dated securities) move more than short tenure securities. That is because long dated bonds will earn higher coupon rates for a longer period in a falling rate regimes and investors are willing to pay a higher price for them. Choose a gilt fund with longer tenor G-Secs for higher NAV appreciation.

Hurst Exponent: This statistical metric measures consistency, volatility and long term expected yields in a gilt fund. High Hurst exponent readings indicate higher stability and consistency in yields. Low Hurst component funds are more volatile and returns maybe patchy and sporadic. Choose a gilt fund with a high Hurst Exponent reading and relax.

Whether interest rates have peaked or not, fixed income investors are likely to enjoy higher yields. It is just a matter of switching horses whenever required.

With the increase in small savings interest rates and investment limits being doubled, getting 7.50 – 8.20 percent in existing fixed income schemes is commonplace. If rates rise, this can get better over time.

If rates have indeed peaked out and a switch to gilt funds is required, you may get up to double-digit returns.

The fixed income party is not over. It has merely shifted venues.

Happy investing!

Vijay L Bhambwani is the CEO of www.Bsplindia.com a proprietary trading firm. He tweets at @vijaybhambwani