Timing rate cuts can hurt your fixed income investments

Ten year government bond yields are at around 8.05% levels while ten year AAA benchmark corporate bond yields are at 9.30% levels. Money market securities of highest rated bank CDs (Certificate of Deposits) of one year maturity are trading at 9.35% levels. Fall in yields in these securities from current levels can give handsome returns to investors in terms of both capital gains and interest income.

The question is what will happen if RBI cuts rates and what will happen if RBI maintains status quo on rates in the July policy? A rate cut is positive for bond and money market security yields and they will trend down post rate cut. However will yields on these securities go higher if RBI does not cut rates? The answer is not a categorical yes. Markets are willing to take a longer term directional call on interest rates and may not be perturbed if RBI does not cut rates in July. 

Bond, swap, and money market yields have come off by 40bps, 60bps, and 70bps respectively since April 2012 to date. Fixed income markets have shrugged off the disappointment of no rate cuts in June to trend at lows for the year. Bond market expectations of rate cuts are not high despite a fall in inflation for the month of June. Inflation as measured by the WPI (Wholesale Price Index) printed at 7.25% for June 2012 against 7.55% seen in May 2012. RBI has not sounded enthusiastic on the levels of inflation and has kept market expectations low on rate cuts.

Bond markets however are factoring rate cuts ahead with expectations ranging from 50bps to 100bps over the rest of 2012-13. The broad trend of the economy is down with GDP growth expectations being revised downwards by economists from government forecast levels of 7.6% for 2012-13. GDP growth is expected to come in below 6.5% as per economists. Global bond yields at record lows due to growth worries is also driving domestic bond yields down. Ten year bond yields from Germany to Japan are at all time lows.

Investors who are bullish on direction of interest rates down the line should not wait for the policy date to pass before investing. The reason is that markets can turn extremely bullish even before the policy and ten year government bond yields could trend down to well below 8% levels. In this environment all it takes for the market to turn bullish is a whiff of expectations of rate cuts. A loose word by a RBI official could be taken positively by the markets leading to a bond rally.

Investors taking a broad directional call on interest rates should not be affected by an event such as a quarterly policy review. One quarter does not change the direction of an economy or of interest rates. No rate cut disappointment in markets will quickly pass and markets will look forward to next policy review rather than worry on previous policy review.

Is it better to invest at ten year yield levels of 8.10% and riding out some yield upside (10 to 15bps) due to rate cut disappointment than rush and invest at 7.9%-7.95% levels if markets turn bullish. The long term trend is what that counts not short term upsides or downsides.

If you bullish on interest rates, do not wait. Invest now.