Make Debt Funds your friend: Basics of fixed income investing Yield Curve

Over the past months or so, I have read a number of financial blogs, where debt fund investors have been advised to avoid and exit long term debt funds. The reason given by most authors was that, “the 10 year yield is at a multi year lows and is likely to bottom out in the near future”. What will an ordinary retail investor make out of that statement? Unfortunately, in our country, when it comes to fixed income investments, the language is so complex, that ordinary retail investors cannot understand it. Investment advisors should understand that, if an investor does not understand a financial product, he or she will simply avoid it. Debt mutual funds offer investors great solutions for a large variety of fixed income investing needs, not to mention, the tax advantage debt funds enjoy over traditional banking products. In Advisorkhoj, our endeavour is to simplify debt fund investing, so that investors can use them in their financial planning.

Debt Fund investing is not difficult

Many investors have told me that, they find fixed income investing (other than fixed deposits) to be very difficult; equity investing is much simpler. I, on the other hand, find fixed income much simpler and equity investing far more complex. Behaviour of fixed income investments is more predictable than behaviour of stocks. Let me explain this further, by asking you two simple questions. The first question, “What do you think interest rates will be, with +/- 1% accuracy, in the next 12 months”? The second question, “Where will Nifty be, with +/- 5% accuracy, after 12 months? Which question will you be able to answer with more confidence? I think most of you will be able to answer the first question with lot more confidence. The concepts of fixed income investing can be quite technical, but if you understand the concept well, even without understanding the mathematics, fixed income investing can be easy for you.

Let us understand some basic principles of fixed income investing, which once you understand, will make life much easier in understanding debt funds. In the first part of this series on the Basics of Fixed Income investing, we will discuss an important concept, known as term structure of interest rates or the yield curve. Throughout this series on Basics of Fixed Income Investing, we will try to avoid mathematical equations, because some of our readers may find these equations to be overwhelming.

Term structure of interest rates

You may have read or heard of the term yield curve on business TV channels or the business section of newspapers. Many readers may not understand what yield curve is, but it is a very important concept in fixed income investing. Yield curve is nothing but the term structure of interest rates. Term structure of interest rate, as the name suggests, is the interest rates of bonds of different maturity terms.

What is a bond? Essentially, a bond is a loan given by you (the investor) to a company (the borrower) or the Government. The company will pay you interest on your loan and return the principal amount at the end of the term (known as the maturity of the bond). Imagine yourself to be a lender. You lend र 100,000 each to two persons. Both will pay interest to you. The first person will repay your loan in 1 year, while the second person will repay your loan in 5 years. What interest rates will you charge the two borrowers? Will it be the same? Under normal circumstances, the answer is no. The risk associated with the first borrower is lower because he or she will return your loan after one year, while the risk associated, with the second borrower is higher because he or she will return your loan only after 5 years. Naturally, you will charge a higher rate of interest to the second person. Therefore, longer the maturity of a bond, higher is the interest rate (under normal circumstances).

What if you lend to the Government (you should know that the Government of India is the biggest borrower in our country)? Surely, there is no risk of default if the Government of India borrows from you (the Government can always pay you back, if required, by taxing you more). Will you expect a higher interest rate if the Government borrows for a longer period? The answer is yes. Why? The reason is very simple, INFLATION. The value of interest payment received in year 5 is less than the value of interest payment received this year because of inflation. If you set aside the jargons and technical aspects of fixed income or debt investing, and focus on understanding the concept, you will find that it is quite intuitive.

The shape of the Yield Curve

Yield curve is a graph, which plots interest rate or yields for bonds of different maturities. The horizontal axis (X-axis) of the graph has bond maturities, while the vertical axis (Y-axis) plots the interest rates or yields (we will discuss the difference between interest rates and yields in our next post, but for now, you can use it synonymously). As discussed above, under normal circumstances, longer the bond maturity, higher is the interest rates or yields. Therefore, the yield curve is usually upward sloping. However, it is important for investors to note that, yield curve is a curve and not a line; otherwise it would have been called a yield line. The curve signifies that, there may be specific maturities, where the yield is less than yields of lower maturities.

Therefore, investors who want higher income from their fixed income investment should focus on the part of the yield curve they are investing in. Investors should also know that, the yield curve is always not upward sloping. Yield curve, though usually upward sloping, can have different shapes, which will have capital gains implications for existing investors and income implications for new investors. Let us now discuss different yield curves shapes and the investor implications thereof.

• Upward Sloping Yield Curve:

  This is the normal shape of the yield curve, as discussed above. The current shape of the yield curve in India is upward sloping. An upward sloping yield curve signifies a strong economy coupled with inflation. Remember, high GDP growth and inflation, go hand in hand; if there is more money in the hands of people, it usually means more inflation.

  Some readers may think that, in the last 1 to 2 years, we had good GDP growth, yet lower inflation. There are periods, when economy slows down, yet inflation remains high. It is mainly caused by some structural issues in the economy and also, very specific to India, due to weather related factors. The current Central Government has been trying to address some of the structural issues, mainly related to supply chain, affecting inflation in our country.

  Also, prior to this year, we had two years of rainfall deficit, which affected food inflation, due to supply side constraints. Over the past year or so, long term debt investors got fantastic returns due to good GDP growth, lower fiscal deficit and lower inflation (top performing income funds gave 13 – 15% returns in the last one year; please see Top Performing Income Funds in our MF Research Centre).

  But from a slightly longer term perspective in the future, expecting high GDP growth and lower inflation, is slightly wishful thinking. If inflation rises, yields will rise and bond prices will drop. New debt fund investors will get higher yields on their investments, but existing debt fund will see a slower growth or even a drop in Net Asset Values (NAVs) of their investments. Please note that we discussed an economic concept, and we are not saying that in India, we are at a point, where we see yields increasing in the near term.

  In fact, over the past one or two months, we have seen the yields of longer maturity bonds compress further, giving good returns to long term debt fund investors. In fact, given the demand (for credit) and supply (liquidity) situation, we can expect bond yields to remain lower for a period of time, which is great news for long term debt fund investors. While the shape of the current yield curve gives important clues with respect to the future outlook on bond yields, investors must pay more attention to the shift in yield curves; whether it is flattening or steepening. Flattening yield curve is always good news for long term debt investors.

• Inverted Yield Curve:

  An Inverted yield curve is downward sloping or in other words implies that, short term yields are higher than long term yields. You may be thinking, how can short term yields (or interest rates) be higher than long term yields (or interest rates)? It is counter-intuitive, but it is possible. Is not the notion of short term yields being higher than long term yields, in dissonance with the concept of risk? Yes it is, but you have to remember that rates or prices are a function of demand and supply of credit. If there is supply of long term credit, but no demand of long term credit, then it is possible that long term interest rates can be lower than short term interest rates. This results in an inverted or downward sloping yield curve. What does an inverted yield curve signify? An inverted or downward sloping yield curve signifies pessimism about economic growth. When the yield curve is inverted, short maturity bonds and short term debt funds, will give higher returns than long maturity bonds or long term debt funds.

  While inverted yield curve is relatively rare it can happen. Investors should known that in 2013, the yield curve in India was inverted. Investors who invested in good short term debt funds in 2012 - 2013 got double digit returns in 2012, 2013 and 2014. If short term yields are high, investors can lock in the high yields, by investing in Fixed Maturity Plans (FMPs), if you are willing to forsake liquidity over the tenure of the FMP. FMP investors in 2012 – 2013 also got excellent returns, with considerably low risk.

• Flat Yield Curve:

  This is usually the most difficult situation to deal with, from a fixed income investment perspective, because you do not know, at what maturities you should be investing in. A flat yield curve means that, both short maturity and long maturity bonds have same / similar yields or interest rates. When is the yield curve flat? A flat yield curve usually signifies uncertainty with respect to interest rates and GDP growth. Since there is uncertainty in a flat yield curve, it is best to go with short term open ended accrual based debt funds. Short term accrual based debt funds, will enable you to earn stable returns in an uncertain environment, till the yield curve assumes its conventional upward sloping shaped or a downward sloping shape, depending on which you can determine you future fixed income strategy.

Yield curve shift

You will hear economist, bankers, fund managers and financial journalists talk about yield curve shifts. But you will find it difficult to relate, what they are talking about, to your fixed income and debt fund investments.

Advisorkhoj.com is a personal finance website; not an economics blog. We try to relate economic concepts to how it affects your personal finance. When you are investing in fixed income securities or debt funds, your investment objective is either income or capital appreciation or both income and capital appreciation. The shape of the yield curve and where you invest in the yield curve, determines how much income you get from your investment. In a normal (upward sloping) yield curve, you will get a higher yield by investing in upper end of the maturity spectrum (longer maturity bonds).

A shift in the yield curve, or in other words, change in yields of bonds determines how much capital appreciation you will get. We will discuss bond pricing in more details in our next post in this series, but suffices to say for now that, when the yield curve shifts downwards, bond prices will increase and you will get capital appreciation (bond prices are inversely correlated to bond yields or interest rates). Therefore, if the yield curve is flattening or seeing a parallel shift downwards, long term debt investors will benefit.

Over the past one year, the yield curve has been flattening. Top performing income funds, as discussed earlier, have given 13 – 15% returns in the last one year. Top performing Long Term Gilt Funds have also given 14 – 15% returns in the last one year. Investors should understand that, the yield curve flattening did not take place overnight (it never does); it has been taking place over a number of months now. If investors had invested in top performing long term debt funds anytime in the last 6 to 12 months back, they would have got very decent (double digit plus) returns. Even if investors had invested in top performing long term gilt and income funds 3 months back, they would have got 7 – 8% returns in just 3 months.

Like prices of other assets, there is obviously an inflexion point in bond prices and yields, from where bond prices will reverse. It is extremely difficult to guess the inflexion point in yields, just like it is difficult to guess the bottom price of a stock. But from a conceptual and also practical standpoint, it makes sense to invest in long term debt funds, when the yield curve is flattening, since you will get capital appreciation. Like stocks, it is very difficult to get the timing right, but unlike stock prices, bond yield trajectory is easier to predict, as discussed earlier. Both bonds and stocks follow business or economic cycles (bull and bear markets), but influence of interest rates in the economy on a bond price is much stronger than influence of broader market direction on a stock price. If you regularly monitor how the yield curve is behaving, you can make very intelligent debt fund investments.

Conclusion

Investors should understand that, debt mutual funds are not risk free investments. Debt funds do not assure returns to investors and, depending on the fund category, are exposed to different classes of volatility risks. One financial advisor once told me that, long term debt funds are as risky as equity. I immediately corrected him because debt and equity are very different asset classes; the risk is not even comparable. I would urge our readers, investors and financial advisors, to take a look at average, median, maximum and minimum fund returns of various mutual fund categories, by going to Mutual Fund Category Returns in our MF Research Centre.

Fixed income or debt investments is more of a science compared to equity investments. I, personally, always found science much easier to comprehend than arts. The performance deltas between top, bottom, average and median performers of different mutual fund categories in our Mutual Fund Category Returns page, will tell you why, fixed income is more of a science, while equity is more of an art. While science may be conceptually difficult for some investors to grasp, once you put in the effort to understand the basic concept, it becomes much easier than arts. The science behind fixed income or debt is quite intuitive, and therefore, I will urge our readers to understand the basic concepts involved in fixed income investing, so that they can make better investment decisions. In this post, we explained the importance of the yield curve. In subsequent posts, we will explain other important concepts, related to fixed income investing, so that you can make more intelligent investment decisions. Stay tuned to our blog.