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Rising Interest Rates The yield on the benchmark 10-year security had touched a low of 5% in the year 2003-04. It has been rising since then and is trading at a 4-year high of around 8.4% touched on 12 July'06. Yields have gone up by over 100 bps since end April'06. But there are few things investors should not lose sight of. One, if our long-term inflationary expectations are in the range of 4-5% then 10-year bond yield at around 8.5% and above offers decent risk premium. Two, the yield curve is very steep. A trader can fund its bond inventory at 5.50-5.75% through repo borrowings. We have not seen this kind of ‘carry’ in last 5-6 years. Three, 10-year GOI bond is trading at around 325 bps over comparable US treasury. We have seen this spread narrowing to just 50 bps in 2004. Even compared to most of the other developed and emerging markets, our bond yields are on higher side. Four, Demand-supply situation in the medium term is not as scary as it looks considering latent demand from insurance companies and provident fund at the long end and SLR demand from banks at short to medium end. Five, if interest rates keep on going up at the pace they have been, our growth story will see serious dents. Whether our government and central bank would allow that remains to be seen. RBI will have to take policy rates much higher from current levels as they are behind the curve. Headline inflation would cross 6% in third quarter. Liquidity will only shrink going forward. There is huge pressure of government borrowing in next couple of months. There is a global environment of rising rates. So there is nothing on the horizon that would make you bullish. Probably what we need to look at is that how much of all this is already in the price? Yields might rise some more from current levels but we are close to a medium term peak. A shining sun always follows dark clouds. For conservative and traditional investors who regularly invest in GOI Bonds / PO Schemes / Bank FDs, it makes immense sense to invest in Income funds / Debt funds now-on going ahead as benchmark yields are very high and attractive at over 8.00%. Also tax free dividends (subject to DDT @14.025%), concessional 10% LTCG and double indexation benefit makes it much more attractive than GOI Bonds (6 years) & PO Schemes (5-9 years). Also Debt Funds offer anytime liquidity. And for those investors who want fixed returns like Banks & Tax benefits like Mutual funds… You got to look for high yield FMPs (Fixed Maturity Plans). Currently Reliance Fixed Horizon Fund (closes on 18 Aug’06) is offering 8.10% yield. FMPs are very simple to understand and are highly tax efficient. Considering your asset allocation, once you are fully invested in Equity Mutual Funds for your long term needs for potentially higher returns, you’ve got to look at FMPs. |
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