Are rising interest rates bad for fixed income funds?
Premium- Capital loss due to higher interest rates may be offset by higher accrual over time
Have you heard this popular narrative? “Rising interest rates impact bonds/fixed income funds negatively, and so should be avoided in such an environment" Well, well. While this appears intuitive, the reality can be different.
Let’s consider that you have bought a fixed income fund with a maturity of 10 years and a modified duration of six years. Let’s say, the yield to maturity (YTM) of the fund when you bought it was 6.5%, and your investment horizon is five years. If nothing happens to interest rates over five years, ₹100 invested will become roughly ₹137 after five years (6.5% compounded over five years, and no capital loss or gain as there was no change in rates). Now, let’s assume interest rates suddenly go up by 50 basis points (bps) after you invested in it. Your worry is that this will adversely impact your returns. Your concerns are valid. There will be an immediate capital loss of ₹3 (modified duration multiplied by yield movement – 6x0.5). However, the fund’s YTM has gone up from 6.5% to 7%. Over the next five years, 7% compounding will become ₹40. Once you knock off the capital loss of ₹3, the end value will be ₹137, the same as if rates had not gone up.
This is just a simple example to illustrate the concept that capital loss due to a rise in interest rates will be offset by higher accrual over time. While we took a sudden one-time rise in rates, in practice, rates may vary over time. Nonetheless, the concept will still hold good. The important catch is the time horizon. The example considers five years given the relatively long duration of the fund. If you were to check fund returns after 1 year, the capital loss component would be pronounced, with the higher carry not having sufficient time to compensate the loss.
Since September 2021, yields have moved up by 100-150 bps in the shorter end (1-5 year) of the yield curve. 10-year G-sec yields have moved up 110 bps. Therefore, different parts of the markets may be offering attractive yields. Further, the yield curve is steep, at every point. Liquid funds are yielding 4.7%, low duration funds (6- 12 months’ duration) are yielding 5.7%, a 20% higher carry over liquid funds. Given the currently steep yield curve, we advise the following:
If you have 6 months plus investment horizon, you are better off with ultra-short/ low duration funds over overnight/liquid funds. Choose moderate duration funds like short term funds, corporate bond funds, banking PSU debt funds for allocations above 18 months, since they will recoup any upfront MTM (mark to market) losses through higher carry over this period.
Do not time your short-term investments. Base your decision on your investment horizon rather than on market levels.
Roll-down strategy funds may be suitable not only for their exact roll-down periods, but also for slightly shorter time frames, given the steep yield curve. For example, a 5-year roll down will work well for any 3-year plus period. As a thumb rule, consider 2/3rds of the fund duration as your minimum ideal time frame.
Arun Sundaresan, head product, Nippon India Mutual Fund