Government bonds enjoy the privilege of sovereign guarantee, hence, they are risk free. Returns factor in inflation rate and thereby, one stays hedged.
We are in a scenario where interest rates have been on a declining mode since January this year. The Reserve Bank of India (RBI), has since steadily been lowering its benchmark repo rate, the rate at which banks borrow money from RBI against the government securities they hold in their portfolios.
The repo rate is now 6.75% from the 8%-level in January. There are advantages either way, if interest rates ease or firm up, for debt market investors, provided the funds are deployed with fund managers who are better equipped to churn portfolios depending upon market conditions. Government bonds enjoy the privilege of sovereign guarantee, hence, they are risk free. Returns factor in inflation rate and thereby, one stays hedged. However, one cannot expect the returns of an equity fund as risks and returns are directly proportional.
What does this mean to the common investor?
A cut in the repo rate signals softening of interest rates – both on loans as well as on deposits.
In such a scenario, how should a depositor insulate against falling interest rates as banks also lower deposit rates along with its lending rates when money is made available to them at lower rates.
After all, the business of banking is to borrow funds through public deposits at attractive rates and lend them onwards through loans at a higher rate to pay back the committed deposit rates as well as earn a profit for the bank.
The government also borrows at market rates through issuance of bonds and these get traded in the secondary market.
Investing in government bonds or government securities hence have an edge over bank deposit rates as returns are usually higher. Besides, these bonds have a sovereign guarantee, so they are risk-free investments. In addition to the advantages, government bonds are usually liquid. This liquidity is seen among highly traded bonds.
Risk-free returns in sovereign bonds:
Prices of government securities (G-secs or bonds), most of which also carry an interest rate or coupon rate, move inversely to interest rates. This means, if interest rates rise, prices of these bonds in the secondary market fall and thus throw up an opportunity to buy them cheap in addition to the coupon rate they would earn. Similarly, when the interest rates fall, prices of bonds firm up leading to capital appreciation in addition to the coupon rate they enjoy at regular intervals.
For every 15-basis point fall in interest rates, the average appreciation on ten-year maturing bonds (G-secs) is 100 basis points and the loss is the same when interest rates rise. The question therefore arises is how does one get to know the interest rate swings in advance?
Hedging against rate cuts
Managers of debt funds often shuffle portfolios based on the number of days or years left for the bonds to mature and a view on future interest rates. It is important for investors to know that maturities range between one day and 30 years.
In the longer time frame, fund managers hold the view of an easing trend in rates but there could be intermittent turmoils of fluctuating rates. Hence juggling portfolios between various maturities not only protects the capital but also optimize returns.
Typically bond yields are higher for longer term maturities as compared to shorter term securities. However, this need not be the case always and there have been instances where yields are distorted or skewed. In simpler terms, it means returns at the longer end begin to equal yields of shorter-term maturing bonds. Under such circumstances, fund managers often shuffle portfolios to shorter maturing bonds. Funds prefer long-end maturing bonds of say 30 years in an environment where returns are higher at the far end as against shorter-term.
In short
The behavior of G-secs often discount future rates and this is where the services of a good fund manager comes handy. There are several highly liquid money market instruments available in the secondary market which enables a fund manger to keep switching from longer end maturities to lower end and vice versa depending upon market conditions. The primary role of any fund manager therefore is to first protect the investors' capital and second, to optimize returns over a longer time frame.
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