Channel name : Mint

Date of the publication : March 31, 2021

Over the past few weeks, there has been a lot of chatter about a “reflation trade” in the financial markets. The theory is that an expeditious vaccine rollout, pent up demand and an aggressive fiscal stimulus will lead to a jump in growth and an increase in asset prices globally. There is concern that this will also lead to a spike in inflation, which has of late led to a jump in bond yields around the world.

But the recent spike in yields is small when keeping in mind the secular decline in interest rates globally in the past three decades. India has also not escaped this trend. The 10-year G-Sec had a yield of around 10.3% in March 2001 that fell to approximately 8% in March 2011 and is at roughly 6.2% now.

Are the forces that have driven interest rates down over a period of decades really going to reverse because of the pent up demand from covid?

This is why a healthy bit of skepticism is required when looking at the return of inflation.We are probably not going back to the high interest rates that we saw even a decade ago but, at the same time, we also have to prepare for a possible short-term spike in inflation leading to some volatility in bond yields.

What are the options for investors when it comes to fixed income? They can either get comfortable with the existing low interest rate environment, or they can try to seek more yield by taking on additional risk.

There are two choices for an investor to increase the yield: take on additional credit risk or increase the duration of papers held.

When it comes to taking on credit risk, the past few years have shown that there is very little liquidity in lower-quality papers in the Indian bond markets.

A series of debt crises, culminating in the saga related to the wind-up of six Franklin Templeton schemes, showed us the risk of going into lower-quality credits. The question that investors need to ask themselves is whether the extra yield is really worth the risk.

Investors could also try reach for yield by looking at high-duration papers, but that brings with it the prospect of higher volatility in the price of the bonds. It is best to save the high volatility for the equity component of the portfolio because fixed income should act as a shock absorber.

In the current interest rate environment, a bond ladder could be one option to look at to spread the risk related to fluctuations in the interest rate.

Laddering involves building a portfolio of bonds with staggered tenures so that a part of the portfolio will mature each year. To maintain the ladder, money that comes in from currently maturing bonds is reinvested in new, longer-term bonds.

A few years ago, creating a bond ladder would have been very difficult for the average investor. However, over the past few years, a slew of target maturity passive debt funds and exchange traded fund (ETFs) have been launched. Many of them have the advantage of having high credit quality, being low cost and passive in nature, and being linked to a target maturity. What’s more, they have significant liquidity advantages over holding individual bonds.

So how does a bond ladder work in a rising and a falling rate environment?

If interest rates go up, the prices of the bond initially fall, but they recover value as they get closer to maturity. When compared with buying a single bond, a ladder has maturing bonds every year that can then be steadily reinvested in higher yielding, longer-term bonds. This helps offset some of the initial price decline when interest rates rise.

When interest rates fall, the price of the entire bond ladder goes up. Maturing papers are then reinvested at lower yields, but the ladder continues to benefit because the shift lower is gradual, and the ladder continues to benefit from longer-term, higher yielding papers in the stack.

In this way, a bond ladder can help manage reinvestment risk and market price risk.

The goal of a laddered bond portfolio is to achieve the returns over an entire interest rate cycle that compares favourably with the total return of longer-term, higher yielding bonds but with a lower market price and interest rate risk.

This is not a strategy for everyone because there will still be fluctuations in the portfolio from market price movements, which some fixed income investors may not want to take. But it is the closest thing that you can get to an all-weather passive strategy in fixed income because it will react and recover in both a rising and a falling interest rate scenario.