Interest rates are clearly trending lower. This means investors must review their debt investment portfolio since interest rates have a bearing on their debt investments. Ignoring the interest rate trend could prove expensive so investors must be on the ball all the time when it comes to making adjustments to their portfolios.
Clearly the Reserve Bank of India (RBI) is responding to the decline in inflation by lowering short-term interest rates. Industry has been increasingly vocal about the need for lower Interest rates and with policy in a rut, the onus of fashioning an economic turnaround has become the central bank’s responsibility.
As rates are lowered money becomes more easily available in the system leading to higher liquidity. Rates at which banks lend money to borrowers like individuals and corporates are closely linked to liquidity. Higher liquidity translates into lower rates for the entire financial system both loans and deposits.
As rates trend lower, bond yields also head southwards. Lower bond yields lead to rising bond prices - this is the inverse relationship between bond prices and bond yields.
As bond prices rise, bond fund portfolios, particularly those invested in longer-dated bond investments, witness a surge in their valuations, which boosts their NAVs. Existing investors in bond funds clock gains on their investments.
With interest rates softening, markets are seeing a sharp fall in bond yields. The yield on 10-year paper has come off 8% at the start of 2013 to about 7.3% in May. Bond markets are buzzing with anticipation of sustained rate cuts and easing of liquidity.
Of course, rate cuts are not a given. The current account deficit remains a concern. Also inflation as depicted by the Consumer Price Index (CPI) continues to be sticky at higher levels as opposed to the Wholesale Price Index (WPI) – so the economy is still grappling with inflation.
What investors should do now
Under the circumstances investors have to keep some points in mind:
1. Fixed income investments like fixed deposits will likely turn unattractive - deposit rates are already falling.
2. Market-link investments like bond funds are likely to see a rise in valuations till there is bias towards lower rates.
So investors must:
1. Avoid long-term deposits.
2. Consider shifting a portion of their debt investments to long-term bond funds to benefit from falling interest rates.
3. Investors with some risk appetite can consider investing in dynamic bond funds - which invest in long-term bond paper depending on market opportunities. Long-term gilt funds are another option for risk-taking investors.