Tuesday, 7 February 2012

Riding the Interest rate curve – Go long at the short end

Fixed Income is synonymous with investments in Debt Securities. However, the returns from them are seldom fixed. The way to maximize the returns from fixed income securities is to know how to “ride the interest rate curve”. By riding the interest rate curve I mean the investor should be aware where and on which segment of the curve he / she is investing in because (risk adjusted) returns can be maximized by being on the correct segment of the curve. Hence, we have to ride the curve correctly to get “higher unfixed returns from fixed income securities”.

When we currently look at and examine the yield curve then we witness that the curve which was steep around 1-year ago has now become flat to inverted. This is because the short end of the curve kept up going with the RB rate hikes while the long end could did keep pace with it. As a result of this, a very interesting story is on the verge of getting unfolded in the 1-3 year segment of the yield curve. Most of the market participants are in consensus about a downward bias on the yields of various maturities based on numerous factors like easing inflation, slowing growth, fall in credit demand, RBI action etc.

Kindly look at the data given in Exhibit I to appreciate the full impact of what I am about to enumerate:

Exhibit I: The Steeping of the Yield Curve

10 Year Benchmark Yield in 14 January 2010
10 Year Benchmark Yield in 2 February 2012
47 bps
1 Year CD Yield on 14 January 2010
1 Year CD Yield on 2 February 2012
375 bps
Interest Rate hikes between Jan 2010 & Jan 2012
375 bps
CRR Rate Hike from
100 bps
Inflation April 2010
Inflation Dec 2011

Hence, as can be observed from above, there has been a major impact on the short end of the yield curve of almost 375 bps as compared to the long end of the yield curve due to the fact of the RBI raising interest rates by almost 375 bps during that period. This can be partly attributed to liquidity tightness which is being witnessed over the past year or so due to various RBI actions and partly due to FIIs pulling out of emerging markets.

All this was done to contain inflation which continued to hover above 9% levels over this period. All the efforts of the RBI along with the impact of base effect has brought inflation (food inflation in fact has gone negative) under 8% levels.

Hence, as mentioned above, now the general consensus is that RBI will focus on growth which has come off significantly due to rising interest rates and other factors like global meltdown etc rather than inflation and announce measures which will help boosting growth once again. Some of the actions in their order of preference would be conducting open market operations (OMOs) to infuse liquidity, CRR cut (both of which the RBI has already started doing) and then finally interest (repo) rate cuts. The RBI in its recent policy review has sprung a major surprise by cutting CRR by 50 bps to 5.50%. This was done to infuse funds to address the structural pressures on liquidity. In the initial phase, this will infuse liquidity to the tune of Rs.32000 crores; and over longer period to the tune of almost Rs.1.50 lac crores through the multiplier effect.

Generally, the RBI buys long dated securities under OMOs. This was evident from the rally which happened in long dated securities from December 2011 onwards when RBI started conducting OMOs. During the same period, there was hardly any movement at the shorter end of the curve in the 1-3 years segment. Exhibit II brings out this picture very clearly:

Exhibit II: Inter & Intra Market Spreads across the Yield Curve

1 Year CD
5 Yr Corp. Bond
10 Year Gilt

However, I believe that, given the present level of liquidity deficit, RBI will continue with OMO auctions, giving support to the bond market as the liquidity deficit is expected to increase in the month of March due to advance tax payment, currency leakage and increased economic activity in the last quarter.

All the above will help in infusing liquidity and as is logical, this will impact positively the short end of the yield curve which was under pressure over last 2 years or so due to liquidity tightness. Also, the fact that 1 year segment had gone up by almost 350-400 bps as against only 50 bps at the long end; this segment is sweetly poised to compress at a faster pace with the RBI’s expected intervention going forward which will help in making the yield curve steeper once again. Kindly note, although there will be southward movement in yields at the long end as well, the same might not be as much in terms of its impact on the yield curve as it would be at the short to medium end. Having said this, in percentage terms the long end might gain more than the short end because of its high maturity and duration but the yield is more likely to compress at the short end. So, on a risk adjusted basis the short end of the curve is looking interesting and attractive. Hence, I would recommend investing in those short term plans which have an average maturity ranging from to 3 years and which can capture the above story well. An investor can expect an annualized yield of 12% to 15% from them over the next 6 to 12 months.