What does monetary policy mean for your bond funds portfolio?

Published: May 4, 2018 12:15:12 PM

From the date of the credit policy announcement, the bond yields are actually up by over 60 basis points. The question is, what does it mean for the investors who are holding bond funds?

bond funds, monetary policy, bond yields, long duration bonds, Fixed Maturity Plans, FMPs, Floating rate funds are ideally suited to rising interest rate scenarios because the rate of interest payable is pegged to the market interest rates.

The RBI monetary policy announced in the first week of April maintained status quo on repo rates. The RBI not only held the rates steady at 6%, but also did not tamper with the CRR and the SLR ratios. But a slightly different picture emerged when the minutes of the Monetary Policy Committee (MPC) were announced in the third week of April. It was clear that the undertone of the policy minutes was hawkish. That means, all the members of the MPC believed that inflation would go up and the only reason they voted for status quo on rates was to prevent the growth momentum getting nipped. Consider the 10-year G-Sec bond yields chart for the last 1 month…

(Chart Source: Bloomberg)

From the date of the credit policy announcement, the bond yields are actually up by over 60 basis points (0.60%). While this is surely a hawkish interpretation of the monetary policy, the question is what it means for the investors who are holding bond funds?

Impact of hawkishness on bond prices

Normally, bond prices have an inverse relationship with the bond yields. When the bond yields rise as we saw post the monetary policy, you see bond prices going down. That means, the NAVs of the bond funds will also go down and that will result in capital losses for bond fund holders. Why do bond prices fall when yields rise? Let us assume that you are holding a 7% bond which is quoting at Rs.100 in the market. If the bond yields in the market go up to 7.5%, then you will continue to earn only 7% on your bond. To compensate for this loss in yield, the price of the bond will come down so that the yield to maturity (YTM) reflects the current market scenario. Let us understand why it is relevant for bond fund holders and how it changes their strategy!

Impact of rising bond yields on long duration bonds

Let us for a moment dwell on the meaning of duration. To put it simply, it is the payback period of the bond. When you own a bond you earn periodic interest and then get back the principal at the end of the tenure. However, since you earn interest in between, the payback period is lower than the maturity. That is why duration for an interest paying bond is less than the actual term of the bond. But why is this concept of duration relevant in rising rates? When bond yields rise, the higher duration bonds are at great risk and see greater price fall compared to low duration bonds. From a strategy point of view, when bond yields start rising or there is hawkishness, you can look to shift from funds that have a higher duration to funds with a lower duration. This will make you less vulnerable to interest rate risk on your bond funds.

Does it make a case for floating rate funds?

Floating rate funds are ideally suited to rising interest rate scenarios because the rate of interest payable is pegged to the market interest rates. Hence the prices of these variable rate bonds are less vulnerable to rising bond yields. But the challenge is that these variable rate funds are really meaningful if the yields are likely to go up substantially. At the current juncture, while 25-50 basis points rate looks to be on the cards, anything higher than that does look unlikely. Under these circumstances, you would be better off either reducing the duration of the bond fund portfolio or temporarily holding your investments in a liquid fund.

Fixed Maturity Plans (FMPs) could be an interesting option

Fixed Maturity Plans (FMPs) are essentially closed-ended funds with a fixed tenure of 1 year, 3 years, 5 years etc. Since they are closed ended funds, the FMP normally buys bonds where the maturity roughly matches with the tenure of the FMP. Hence, the FMP almost becomes like a low-risk, assured return scheme. Since the maturity profile of the fund and the bonds are matched, there is also no interest rate risk for the investor. If you are willing to lock in your funds for a fixed period, then FMPs could be your answer to interest rate risk. These FMPs are also structured in such a way as to give you double indexation benefits, thus improving your post tax returns.

(By Jaikishan Parmar, Senior Equity Research Analyst, Angel Broking)

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