It’s a good time to make those fixed-income bets

Why invest in longer-maturity fixed-income products when one-year fixed deposits are giving you 10% and above or one-year fixed maturity plans are giving 9% and above?

Longer-maturity fixed-income products include government bonds and corporate bonds having maturities of five years and above or gilt and income funds that invest in long bonds. Long bonds carry higher risk of capital loss in the short term if interest rates go up and given current inflation levels of close to 9%, interest rates are looking to trend higher. So why invest at the long end of the curve when the short end is giving good returns?

The answer is, because short-end rates are high, interest rates at the long end of the curve is likely to come off in the medium term. How does one make money if interest rates come off at the long end?

An example would be in order here.

The ten-year government bond yield (7.80% 2021 government security) is 8.35%.
If government bond yields fall 75 basis points (bps), or 0.75 percentage point, the one-year holding period return is computed as follows:

Price of 10-year government bond = Rs96 @ yield of 8.35%
If yield falls 75 bps, price = Rs101.40 @ yield of 7.60%
Capital gain will be Rs101.40 - Rs96 = Rs5.40
Interest earned or coupon for a year = Rs7.80
Holding period return, which is capital gain plus coupon = Rs13.2
In percentage terms, holding period return is Rs13.2/ Rs96 = 13.75%
The math is fine.
But why should yields fall when inflation is high and the government is borrowing heavily?  

Inflation is running at 9% levels while the government has projected a fiscal deficit of 4.6% of GDP for fiscal 2011-12, entailing a net borrowing of Rs340,000 crore. In all probability, the government borrowing is likely to go up as oil prices (higher by 25% in calendar 2011 to date) are pushing up the subsidy bill as high oil prices are not passed on to the consumers. The reason for expecting bond yields to go down is that inflation is likely to come off from high 9% levels, giving the Reserve bank of India room to hold on to or even lower policy rates down the line.

The factors driving inflation are on the ebb; food inflation is down from high double-digit levels to single-digit levels over the last eight months; central banks across the world from China to Brazil have raised interest rates to curb inflation and prevent economies from overheating and the prospects of economic growth globally are better, though not strong due to the debt crisis in the euro zone, US unemployment at close to 9% levels and Japan natural disasters restricting growth.

India, too, will see credit growth come off as lending rates go up on the back of the lenders’ cost of funds going up due to RBI rate hikes. Banks will be more inclined to buy government bonds as liquidity improves on the back of high deposit rates and credit growth slows down on high lending rates. Bank buying of government bonds will take care of any excess supply and demand for bonds will increase from other quarters once inflation is seen coming off from peaks.
Investing directly into government bonds for small investors is not an easy option. Gilt and income funds, which invest in government bonds, are a better option, though expense ratios are too high (at 2%).
    www.arjunparthasarathy.com