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How to profit from rising interest rates

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For whatever its worth, we always work towards times we expect the most but hope the least for. Stock markets are risky investments. Everyone who chooses to invest is made to read the prospectus before making any decision, and rightfully so because one must understand the upside as well as get the contrarian way on the upside.

The best time to invest is when everybody is selling — Warren Buffett.

For many years, stock market has been referred to as some kind of betting one has to play in order to be able to come out victorious, only to continue playing again because not all strategies is going to work in your favour. The effort is continuous and success is often short-lived because investors might need another swing at it.
Let’s be honest, not all strategies work in our favour. When interest rates are scraping the bottom of the barrel, we often forget that they will go up. Most financial advisors stick to the short-term or medium-term investments. Most investors follow their advice out of the fear of losing on growth because long-term investment might mean chances of losing are far greater than in short-term or medium-term investments.
Many bond/finance managers have administered to find a way for investors to make money in almost all market conditions. This is the main focus of this blog — to be able to lay out some strategies that preserve your capital, force growth, and render a regular source of income.

Long-term Bond Conundrum

For the most part, the claim, or analysis, that long-term bonds are more sensitive to increase in the rates is a widely known fact. But, the bond market is more than the widely followed expression. The ground is more nuanced than what is known at the surface. Just like a cow in every region mows in a different accent, BondsIndia believes every bond is affected differently by the rising interest rates.

Having said that, bonds indeed suffer when the interest rate increases, but not as much as it is said in the articles on the tons of websites. Or, claimed by some financial experts. A bad day in the bond market is still better than a bad day in the stock market. Losses incurred in bonds are far lesser than that of stocks.

The losses are short-lived and derive more growth because as interest rates starts to rise, the inclusion of new bonds also comes with it, which pay you higher coupon rates. The inclusion suggests that because bond investors expect more bonds with higher interest, they will demand bonds with coupon payments at par with the market.

Many bond/finance managers have administered to find a way for investors to make money in almost all market conditions. This is the main focus of this blog — to be able to lay out some strategies that preserve your capital, force growth, and render a regular source of income.

How to prepare for rising interest rates

Market conditions are different each time. You cannot follow the same plan of action every time. It needs a more nuanced approach, and BondsIndia highlights some strategies in this blog post. Please be informed that these are not personalized suggestions and may not concern your particulate situation. The strategy changes with every little change that happens in the market. Here goes:

Every bond is affected differently

When a certain type of bond performs poorly, it affects the demand of that bond in the market. The demand is often quantified on the basis of the company’s financial conditions, default risk, and the industry it falls under. Investors often make the mistake of seeing it as a failure of the whole bond industry, then the small strata of affected bonds.

Indian debt market consists of various debt-instruments that are issued by either government or companies. Each bond carries a different credit rating and maturity. Unlike stocks , two bonds issued by the same issuer also may not be identical

Debt Instruments Issuer Short Term Long Term
Commercial mortgage-backed securities (CMBS) Government of India Less than 91 days No
Treasury bills Government of India Up to 364 days No
Government securities (G-SECS) Government of India Minimum two years Up to 40 years
State development loans State Government Minimum two years Up to 10 years
Commercial Paper Corporations 270 days No
Non-Convertible Debentures (NCD) Corporations 90 days 20 years
VAdditional Tier 1 bonds Banks Perpetual Perpetual
Additional Tier 2 bonds Banks Perpetual Perpetual
Certificate of Deposits Banks One year No
Fixed Deposits Banks/Financial institutions Minimum 7 days 10 years
Commercial Papers Financial institutions Up to one year No

Just as we see above, debt market is far-reaching and bond market at that, introduces bonds in various forms issued by different entities, and each entity has a customer base which is different from the other. A customer investing in G-Secs might not prefer liquidity on their investment primarily, while someone invested in a money market instrument such as Commercial Paper might be in a need of a liquid asset. The stark difference between the customer’s baselines for essential separates each bond segment from the others.

Interest rates and yield are antithetic

The term interest rate often tries to skip the more nuanced game at play. Meaning, it is used so much that investors completely forget to think about yield. We often focus on ‘ if the price of the bond decreases, the yield of the bond increases,’ instead of, “ if the interest rate falls, bond prices increase.”

Interest rate or the coupon remains constant throughout the life of the bond, whereas, bond yield change as many times as it can/should until the date of maturity. Various factors affect the yield of the bond e.g.) Price, Demand etc

For example, if the coupon of a bond is set at 7%, then it will remain the same, no matter what, for the entirety of the bond.

Interest rates and yields

  • ● Interest rate is percent of money, lender gets on the investments.
  • ● Yield is the net return made by an investor from their investment

Let’s say you purchased a bond for ₹1000, at 5% interest but its price right now is ₹980.

Face Value 1000
Coupon 5%
Annual Interest ₹ 50
Price of the bond ₹ 980
Yield 5.1%

Face Value of the bond is the amount an investor has paid at the time of purchase. It is also known as par value. Face value is also what you receive at the time of the bond’s maturity. Coupon refers to the interest rate on a bond. If your bond is for ₹1000, and you get ₹50 annually, then the coupon rate of your bond is 5%.

The yield of the bond comes to be at 5.1%. On the other hand, if the price of the bond is more than its face value, it is selling at premium. Let’s understand that with an example.

Face Value 1000
Coupon 5%
Annual Interest ₹ 50
Price of the bond ₹ 1050
Yield 4.76%

Bonds can totally be sold more than their face value because of the change in interest. They are no different from other fixed-income securities that are always at cross purposes with the interest rates. The only issue with some premium bonds is the call feature. If the bond can be called upon anytime during its life, then the investor stands to lose the principal. Look for investing in bonds at premium when the rates are low.

Over the long term, higher interest rates can be a good thing for bond investors

High yield corporate bonds are generally not sensitive to changes in Government Bond yields.  High yield corporate bonds, generally speaking, perform better when the overall economic climate is improving, as this typically drives lower bond default rates.  Such periods are often associated with rising government yields and rising interest rates.  Further, many corporate bonds are not sensitive to changes in interest rates and have continued to perform well in spite of rising interest rates.

Rising interest rates can drive higher bond coupons and yields on many future corporate bond investments.

Look for less sensitive bonds

The word sensitive being the operative word here, in the bond context it means, fixed-income securities are susceptible to the rise in interest rates. Some experienced investors, who have been in the market for a long time, understand the quandary behind chasing bonds that might drop in value when the interest rates are on the upward direction. Just like some people are more sensitive to dust than others, some bonds are less sensitive to market movement than other bonds.

There is a litany of information on the internet that suggest investing in high-yield corporate bonds are a safe and excellent choice for investors who do not want their investments to be affected by the change in rate of interest. Having said that, high yield corporate bonds are not always rated higher by credit agencies. They are more likely to not pay the interest or the principal at maturity, but offer high yield bonds offer higher interest which leads in rendering additional income. Investors usually assume capital appreciation and hope the company in question might improve their financial health in future.

Credit ratings are opinions provided by the independent credit rating agencies. Just like tests determine our strengths, credit ratings determine the strength of a company. Starting with AAA being the highest and anything below BBB being risky, the ratings give us an idea whether or not the company is able to manage their finances well at present as well as in the past.

Investors make a decision based on the credit ratings provided by the credit agencies, who classify them into either investment grade or non-investment grade. High yield bonds are non-investment grade bonds, which should offer higher interest. The ratings of these bonds are usually below BBB. Anything above that is rated investment-grade bonds.

One must invest in Bonds based on their investment goal and risk taking capacity. There is a bond for every investor, it’s all about finding the right one ! Hop onto BondsIndia Knowledge Centre and understand how to select your Mr Right!

Look for less sensitive bonds

In order to understand what accelerate the bond price, one must consider a lot of factors like Ongoing benchmark yield, Liquidity, Demand, Credit Rating of the Issuer, Maturity Interest Payment Frequency timely payment of interest etc. “. If you are a newbie investor, go for more liquid bonds

The investment secret remains the same “Buy when the prices are low

Simply avoiding long-term bonds won’t help.

Bond investment is one of the best ways to preserve capital, but we still use the traditional strategies when it comes to considering the duration of a bond. The Bond market requires new thinking.

It goes without saying that the 10-year bond yield is stuck at 6% for over a year. The market has many faces that react differently to the economic conditions and interest rates. Stating it simply, each segment is hit differently when the interest rate rises. Sometimes, the overall performance of the bond market is far from being considered as negatively affected.

The solution to this is to invest in high grade corporate bonds. This kind of investment maximizes investment returns and narrows down the possibility of losses. Limiting your bond investment bracket to short-term bonds is not a good strategy, as far as we are concerned.

Own individual bonds rather than bond funds to take advantage of buying and selling opportunities

Most investors underestimate the investment returns possible in the corporate bond market.  Many believe bonds are just for clipping coupons and don't appreciate the strong capital gains and total returns individual corporate bonds can achieve.  A key difference between owning individual bonds vs. bond funds is the level of pricing volatility and the ability to buy low and sell high to maximize capital appreciation and total returns.

Some investors may prefer the lack of volatility, and that's okay. That said, these investors are taking capital appreciation off the table. The investment strategy is to maximize capital appreciation and total returns.

Buy long-dated investment grade corporate bonds when their prices fall significantly

The follow-the-herd strategy in periods of rising interest rates is 'to stay short,' or to buy bonds with near-term maturities to limit paper losses due to rising Treasury yields.  For investors satisfied with 1-2% annual returns and little hope of capital appreciation, this is a fine strategy.  It's important to keep in mind; however, that investors focused on interest rate risk can still buy longer-dated high yield corporate bonds and not fear an investing apocalypse should 10-year G Sec yields tick up half a percentage point.

Often times, long-term investment grade corporate bonds are the Rodney Dangerfield of investing, getting no respect.

Be prudent

Many stalwarts of the bond industry feels that if after the initial investment, the bond price falls, and the company is doing great financially, then invest some more in the bonds at the lower price. Invest in short-term as well as long-term bonds over the period of time, considering the various factors that determine the financial health of the company, instead of going all guns-blazing at once . In a nutshell “ Keep your bond portfolio diversified. Invest in bonds to bring in stability and diversity thereby enabling you to create a secondary source of income!”

Parting words

It is proven time and again that the “rise in interest rate” is overblown. Many feel that having a foresight to such things will make them a part of the safe environment, but instead, they are only following what’s trending in the market, and what’s spread in the media through social media platforms. One great way of doing this is to do your own analysis instead of spending time going through what the credit rating agencies have to say.

Indian bond market has always been the talking point when the interest rates have started to go up. Low interest rates should also work as a driver for the investors to reach for that extra yield bond by changing the time period of the bonds. There is bad, but there is also good, and to interpret that is what separates an investor from a player.

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