Bond market moves, in times of sticky yield & high interest rates

This time last year, as the world started to step out of the pandemic with the Ukraine Russia war as the backdrop, it was all doom and gloom in the equity markets. World over, inflation was soaring on the back of excessive money printing prompting central bankers to sequentially raise rates at a feverish pace to tame the price rise. India too followed suit (though high inflation was something the country was quite used to) with the expectation being measures are temporary and a lower interest rate may be required for both government borrowing programmes and for industry credit for enhancing production.

The increase in tax on bond funds made little difference on account of investment grandfathering and low retail participation in such funds as per various regulators and the finance ministry.

Now there is a peculiar situation, while there was renewed interest in bond buying a month ago which dipped the bond yield to below 7 per cent, it has now bounced back to above 7 per cent hitting a high of ~7.5 per cent. An Exchange-Traded Fund (ETF) investing in long term (7-13 year) government security (GSec) has returned 12.4 per cent (Source: Google Finance LTGILTBEES) in the past year through bond market volatility.

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In a market with stubborn yields, and persistent high rates, what can investors look at?

Yield

Firstly, the yield itself is interesting. From purely a risk perspective, a 7 per cent 10-year Government of India bond somewhat covers inflation (before tax) and that remains unchanged for the life of the bond much like in the US where the current 5 per cent+ yield on Treasuries (US government bonds) may be quite attractive to some.

Bond Math

However, this is also where the inverse relationship between bond prices and interest rates comes in – when these rates start to cool off (go down), the bonds, which offer a yield better than the prevailing interest rates, look more attractive to investors leading to a higher demand and price. There is uncertainty about when the interest rates will go down (or rather when a central bank like RBI may cut rates). In the absence of a rate cut, the investor cannot hope for capital gains from bond price escalation and has to contend with only the yield on the instrument held.

Bonds v/s Debt Funds

Having said that, since April 2023, the mode in which one holds bonds has a bearing on returns on account of differential taxation. Directly purchased bonds attract long-term capital gains with indexation after one year. However, the periodic coupon payments on such bonds are added to income and taxed at income tax rates. So, this is a beneficial mode of holding in a falling interest rate regime.

On the other hand, when investing in a bond fund, the entire returns are now added to the investors income and again attracts tax at income rates. However, there is no tax liability till one redeems those mutual fund units. This means the investment keeps compounding till redemption, resulting in better absolute performance.

Bonds or even other fixed income investments are critical for investor portfolios, and they do provide a hedge against volatility in equities. But it is important to understand interest rates and where they are headed, to comprehend the kind of investment suited to their needs. It is also recommended one consults an advisor or banker before investing to get an understanding of prices and expectations.

(The writer is Managing Partner, Aryzen Capital Advisors)