With Rising Interest Rates, It Makes Perfect Sense To Invest In Bonds. Its Commonsense Investing

Rising Rates and Bonds

The volatility in financial markets will not end soon. Yet another investment manager said that investors would have a long wait for returns to turn favourable.

The chief executive of Norway's Norges Investment Bank, the world's largest sovereign wealth fund with assets of $1.3 trillion, told at a World Economic Forum (WEF) event that a long period of drab return lies ahead for investors.

And that is because interest rates are expected to continue rising in the near term.

Why are interest rates rising?

While there is an expectation in some quarters that the US will start cutting interest rates in late 2023, Nicolai Tangen, the CEO of Norway's national fund, said a new cycle of rate hikes in the US is "not that unlikely".

Central banks around the world are not yet done with rate hikes as they fear that China's post-Covid reopening will push commodity prices up, and consequently inflation.

Led by the US Federal Reserve, central banks worldwide, including the RBI in India, could continue to raise interest rates to contain inflation.

The Reserve Bank of India's governor, Shaktikanta Das, also recently observed that central banks must be vigilant about inflation.

So what can investors do?

Rising rates open up opportunities for investing in bonds. 

Conventional wisdom is that rising interest rates spell trouble for equities because the cost of capital rises.

It also results in bond prices falling as institutional investors expect fresh bond issuances at higher prices.

Usually, when interest rates are likely to rise, it is advisable to buy shorter term bonds, and to buy longer duration securities when rates are likely to fall.

Yet, a rise in interest rates is good for those who save, but bad for those who have loans.

What should the approach be?

A rise in interest rates is generally good news for savers and investors because banks and bond issuers are likely to offer higher interest rates on deposits and bonds.

If interest rates rise more, then investing in medium-term bonds or bond funds that mature in five-to-10 years can boost income in your portfolio.

Staggering the maturity profile of bonds can also provide flexibility to make changes as interest rates change.

A more aggressive approach to investing in a rising interest rate scenario is to keep buying bonds, debentures, gilts, or other similar fixed income instruments to lock in higher yields.

What can you buy?

Investors must have bonds in a portfolio because it can provide stability to your portfolio by bringing in a steady income stream.

The reality is while stocks have reached stratospheric valuations, bonds are available at good yields.

In fact, the bond market has securities with yields that are attractive, relative to other investments.

A portfolio of high-quality bonds such as gilts, investment-grade corporate bonds, market-linked debentures and perpetual bonds can be investment options that can be considered for investments.

There are also Floating Rate Bonds issued by the RBI, tax-free bonds of select public sector companies, InvITs and REITs.

Retail investors can also buy Government of India's Treasury Bills. The RBI's recent auction of 91-day T-Bill was at 6.4085%, 182-day T-Bill at 6.7955% and 364-day at 6.9012%.

Then there are Bharat Bond ETFs that mature over 2030-2033 that offer yields of 7.54% to 7.58%.

The Bharat Bond ETFs invest in investment-grade debt securities of public sector companies.

Retail investors can use the current fixed-income market scenario to build a good quality steady income stream.

Bear in mind that, it is difficult to predict the performance of the bond market. It is dependent on various factors such as global central bank's policies, macroeconomic conditions, and political developments. However in relative terms when considered against stocks, investments in bonds are relatively stable.

After a period of low yields and price drops, the bond market may provide attractive yields at lower risk for investors in 2023.

Investors must also bear in mind the post-tax yield. Bonds held for three years or more qualify as long-term capital gains and are subject to a 20% tax rate with an indexation benefit.

For more information, write to bondbazaar - connect@bondbazaar.com

Happy Investing !