This September, buy into bonds to get a good return on investments over the next six months to one year. Buying bonds makes sense when the yields are high. When the yields start coming down, bond prices go up and investors can earn capital gains.
However, the scope for retail investors in our country to invest directly in bonds is limited both in terms of market expanse as well as product categories.
Besides, investment in bonds is more tricky compared with equities. The best and the easiest way for small investors to invest in bonds is through debt mutual funds.
Easy way out
Short-term debt/income funds or dynamic bond funds should be your pick. This is because whenever there is a fluctuation in interest rates and/or the inflation rate, the volatility is more prominently reflected in the variation in yields for bond/debt securities of smaller duration.
Before we discuss why you should consider bond investment now, let us understand how yield and bond prices change.
A bond is a debt paper which an issuer wants to issue to investors to raise funds for a specified tenure. An investor won't invest in the bonds unless he gets an interest payment. The interest rate offered in a bond when it is initially issued is called the coupon rate.
Suppose, ABC Ltd came out with a bond issue offering an interest rate of 10 per cent and each bond was sold for Rs 100. Mr X, who had bought one bond from the initial issuance, would have invested Rs 100. The investor will earn an interest of Rs 10 every year till the end of the specified tenure when the bond comes up for maturity and the issuer pays back the investor his initial investment of Rs 100.
Suppose, the interest rate in the market after a year of the initial issuance went up to 15 per cent. Would you be ready to pay Rs 100 and buy from Mr X the bond that fetches an annual interest of 10 per cent? Certainly not. If you put Rs 100, say, in a bank deposit, you shall get 15 per cent interest.
In other words, given the market interest rate at 15 per cent, you will pay only Rs 66.67 for the bond that gives you a 10 per cent interest.
Thus, the price of bonds that Mr X had bought now falls to Rs 66.67 from Rs 100 a year ago. But each bond still continues to earn its investor an annual interest income of Rs 10. If you buy this bond from Mr X for Rs 66.67, the percentage return of your investment works out to 15 per cent, provided you hold on to the bond till maturity.
So, you see, whenever the market interest rates go up, bond prices fall and yield goes up.
Similarly, whenever the market interest rate goes down, bond prices go up and yield comes down.
It is now clear that investment in bonds/debt mutual funds makes sense when bond yields are likely to fall and give rise to capital gains.
That the market interest rate has reached a plateau and is only going to go down in the days to come is anybody's guess. In fact, the southward movement of interest rates started since April when the Reserve Bank lowered its policy rates by 0.5 percentage points.
However, yields on government securities, the safest investment instrument and an indicator of the interest rate movement, also fell, though marginally. High inflation rate, a tight liquidity condition and continuous market borrowing by the government stemmed the fall in yield in government securities.
Interestingly, the yield on 10-year government securities (8.15 per cent G-sec 2022), the benchmark indicator, soared to 8.25 per cent as on August 6 from 8.17 per cent on July 30.
The Reserve Bank, in its monetary policy review on July 31, unexpectedly reduced the regulatory requirement for banks as to how much of the net deposits they should invest in government securities.
The reduction in SLR requirement from 24 per cent to 23 per cent from August 1 means banks can now buy less quantity of government securities from bond auctions and will have Rs 62,000 crore more to lend to corporate and retail borrowers.
Though the credit demand in the banking sector is sluggish in the face of slow economic growth, banks are unlikely to dilute their existing SLR portfolio estimated at more than 27 per cent ' that is, 4 percentage points above the regulatory requirement. Why? Bankers say that this excess holding of government securities will help them in borrowing money from the Reserve Bank through its repo auction window under the liquidity adjustment facility (LAF) going forward when credit demand picks up in the busy second half (September to March) of the financial year.
September is also the time for payment of advance taxes by individuals as well as corporate tax payers. Hence, liquidity in the system is expected to be tight which is why the RBI tried to preempt this situation by lowering the SLR requirement and ease the liquidity now.
But till August 3, the government has borrowed Rs 2,57,000 crore from the market ' only 45 per cent of its budgeted target for the entire financial year. The government also targeted to complete 65 per cent of the market borrowing during the first half of the financial year to avoid crowding of private borrowers in the later part of the year.
If the government has to stick to its market borrowing target in the first half of the current financial year, it has to borrow another Rs 70,000 crore by the end of September.
Along with this, the inflation rate is also likely to go up from the current level following the draught-like situation affecting kharif harvests in many parts of the country.
If inflation goes up, the government will have to offer a higher yield to attract investors for its pending market borrowing.
The yield on 10-year G-secs has already reached an attractive level to invest in. If it goes past 8.40 per cent mark, it will be worth investing in bond funds. Sooner than later, the RBI will have to reduce the interest rate to bolster economic growth. Once this happens, bond investors will be in for a capital gain.
Historical data shows that the 10-year G-sec yield was at 8 per cent on an average for the period from 1998 till 2012. It touched a peak of 12.3 per cent in February 1999 and reached a bottom of 5 per cent in October 2003. During this period, bond investors saw their capital investments appreciate nearly 2.5 times.