Investing at the top of the interest rate cycle | Mint

Investing at the top of the interest rate cycle

Just as with equities, investors can make potentially large capital gains in debt as well. (iStockphoto)
Just as with equities, investors can make potentially large capital gains in debt as well. (iStockphoto)


  • While debt is usually boring, it can get quite exciting when you are at the top of the interest rate cycle

Would you buy 50-year government bonds?

This was a question put to me recently. My gut reaction, no I would not. At least not in India. I am assuming that you, or in any case, most, would agree with this view.  

Why invest in a bond that yields 7% per annum when perhaps the effective household inflation is perhaps much more than that? That would be akin to destroying capital.  

If this rationale is too intellectual, we can offer a more palatable one. That over such a long period, stocks are very likely to deliver a lot more than 7.2% pa returns, so that’s a far better bet.  

Either way, chances are you don’t dabble in listed debt. The closest you have probably come to that is a debt mutual fund, or indirect exposure via some government savings scheme.

There’s a reason why we are discussing a low yielding investment today. That’s because while debt is usually boring, it can get quite exciting when you are at the top of the interest rate cycle.  

Just as with equities, you could make potentially large capital gains in debt as well.  

You see, in the case of equities, the value of a stock is effectively the discounted value of the potential dividends you will receive in future. Any increase in dividend expectations, all things remaining the same, the price of the stock will move higher. And vice-a-versa.

Now let’s focus on the other variable. The interest rate. If the rate at which you discount the dividends goes up, then, everything else remaining the same, the value of the stock will go down. And vice-a-versa.

When you think of a bond, it’s very similar. The value of a bond is the discounted value of the interest payments you receive from it for the life of the bond.

Let’s take, for instance, a bond that pays 7% pa over a 10-year period. The face value of the bond is Rs1,000. Since the bond is issued today, when the interest rate for such bonds is 7%, the market price should be about Rs1,000 itself.

Now, assume that the rate at which you discount the bond changes to 6% because interest rates in the open market are headed lower. Now what happens to the bond price? 

Well, all things remaining the same, it will now trade at Rs1,073 (you can figure this using any simple bond calculator). That’s a capital gain of about 7.3%. This is over and above the annual interest of 7% that you will continue to receive for the year (note: if you hold the bond for longer, the capital gain will be lower, unless, of course, interest rates fall even lower).

Pretty attractive, right?  

There’s a lot of merit in buying bonds at the top of the interest rate cycle. You could ride down the interest rates all the way and cash in the capital gains, while continuing to earn a far higher than market rate of interest.  

The case for bonds is solid.  

The lowest hanging fruit here is the government of India bonds, of course. These are sovereign, so default is pretty much ruled out. State government bonds, which pay out higher rates than Central government bonds, fall under this same bucket. Given that both offer sovereign guarantee, the state government bonds are perhaps the more attractive bet (I saw a 0.5% differential in one case, which is huge). I would also check out PSU bonds, which explicitly confirm the guarantee.  

One more thing about sovereign guarantee bonds. If you want to boost your returns in a falling interest rate environment, then the longer tenure bonds are best. The longer the tenure, the bigger the boost when rates fall. If in the example above, the 10-year tenure was changed to 20 years, the capital gain would jump from 7.3% to 11.5%.

This is where the 50-year bond comes in. Here, the immediate capital gain would be 15.7%. So it may be an interesting opportunity after all. But not to hold it. Instead to trade the interest rate downcycle.  

In case you are wondering, yes, there’s a big private sector debt market too out there. And various kinds of debt. Perhaps we will revisit that later. Today, let’s stick to low-hanging, almost zero-default risk, opportunities, i.e., government-guaranteed bonds.  

Here are some things to keep in mind when investing in government-guaranteed bonds: 

1. Interest rate movements are never guaranteed. If interest rates move against you, i.e., higher, you will suffer an interim capital loss. So before you pull the trigger to invest, do your research well. 

2. Your asset allocation has a place for interest-paying instruments. Even if you are a perma bull. As you can see from the example above, investing smartly in bonds can be a source for solid returns without exposing yourself to things like default risk. 

3. As you would with stocks, over time you could consider having a portfolio of bonds as wwell. Of course, perhaps start with guaranteed bonds. And over time, as your understanding develops, you can widen your scope to private sector bonds.  

Having said that, there could be challenges in doing this. A simple alternative to this is to buy a bond mutual fund that meets your requirements. But if you do go down this road, be sure to check under the hood, i.e., which bonds does the scheme own. You don’t want to take the risk of default, especially if you are just starting out as a bond investor.  

Finally, if you are indeed open to investing in bonds issued by the government of India, should you consider investing in dollar denominated bonds as well? Perhaps. But then that exposes you to additional risk and requires you to have an even broader understanding of the investment environment.  

PS: Till recently, the world was focused on the possibility of rising interest rates and its impacts of investors. And now, in a matter of a few short days, the entire narrative has changed. Just shows how volatile interest rates can be at times.  

Rahul Goel is the former CEO of Equitymaster. You can reach him on X at @rahulgoel477.  

You should always consult your personal investment advisor/wealth manager before making any decisions.

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