US Federal Reserve’s decision to withdraw fiscal stimulus package has been an event of immense significance this week. Its magnitude can be measured in terms of panic situation it has created among global investors, who are selling in Indian markets. It has adversely impacted Indian equities, bonds and currency. While equity investors are familiar with volatility, bond investors however are caught unaware, especially after a smart rally in bond markets in last one year. Given this situation, it is important to understand how this influences returns on our fixed income portfolios. Here is a low-down:
For beginners, this mayhem has genesis in the expectation of US Federal Reserve stopping its easy monetary policy in next one year. The open strings of US Fed's purse ensured abundant money available at near zero interest rates. This money invariably came to emerging markets like India and pushed up asset prices. However, now the table seems to be turning. As the easy money policy in the US is expected to moderate, the momentum in emerging economies – the rally in various asset classes in emerging markets – is expected to lose vitality. As liquidity dries up in the US, money will go back to dollar assets and in turn will end up depressing other currencies, including the Indian Rupee. Currency markets have factored this point. Naturally, the Indian Rupee in relation to the dollar is about to hit level of 60 rupees per piece.
But what has a fixed income investor got to do with a weak rupee? A weak rupee means inflation. India imports inflation when INR goes down against American dollar. We import crude oil which is priced in USD. Oil comprises nearly 70% of our total import bill. Costlier crude oil indicates -costlier petrol-diesel and inflated energy bills which in turn initiate a vicious cycle of inflation. Rising inflation does not offer any room for the Reserve Bank of India to cut interest rates in India. Higher inflationary expectations bring down the expected real returns in the economy and hence the long-term interest rates need to be pushed up to reward investors.
India’s bond markets investors know this. A 10-year benchmark bond yield moves up to 7.43% from a low of 7.08% recorded on 24th May this year. When the bond yields move up the bond prices move down. Naturally the bond investors are losing money. Mutual fund schemes investing in the long-term bonds, especially long-term government securities are losing money. A case in the point is long-term gilt funds. In the last fortnight, long-term gilt funds have faced an average loss of 1%.
For the last one year or so, most investors were keen on chasing long-term bonds hoping for a fall in interest rates. The expectations materialized too, rewarding investors with handsome gains. Even if one accounts for recent losses, investors have made more than 12% returns in long term gilt funds in the last one year. But things may change from here. It is time to revisit your bond fund strategy. The secular bull-run in bond markets is probably stopped. Long-term bond yields may remain volatile for some time now and one may see mark-to-market losses in the near term. However, do not lose heart.
You may continue to hold on to your investments in the long-term bond funds provided you have patience and strength for high volatility and a timeframe of 12 to 18 months. The expected economic recovery in the US may not happen and the liquidity may be re-introduced, which may fire another liquidity driven rally. The Indian economy is yet to see revival and if it continues to remain low, then RBI may be keen on cutting interest rates. But, in the meantime, it is important you should remain optimistic. If you are contemplating fresh investments consider investing in the short-term bond funds, where the sensitivity to interest rates is low. Invest with a one year time frame and you will take home tax-efficient returns. A point to note here is long term capital gains arising out of investments with more than one year time frame in debt funds are taxed at a rate lower of 20.6% after indexation and 10.3% without indexation.
The author is the Director & Co-founder, creditvidya.com