How floating rate systems can help as rising rates loom

Manish Banthia: What’s happened over the past few years in the fixed income space is that we’ve only seen returns in one direction. From 2014, when 10-year yields were as high as 9.5% to their current level of around 7%, yields have only fallen.

In the shorter end of the curve – the one- to two-year yields where investors normally invest wholesale – FD rates only saw a downward trajectory. It is therefore an interesting time to reflect on what one should do in terms of fixed income investments when things have changed.

The past two years have been years of recovery for the economy. When the economy is in recovery, there is another type of investment opportunity you need to look into in the markets. But when the economy has moved from recovery to expansion, when capacity utilizations fill up, your inflationary pressures increase. Interest rates in these environments tend to rise.

In a rising interest rate scenario, a fixed yield bond may not normally be the right instrument to invest in. In a fixed-rate instrument bond, if you have a three-year bond, you’re fixing your yield right now. If the returns are going to increase, in this journey you are going to lose money.

On the other hand, when yields fall, if you invest in a fixed rate bond as yields fall, you actually earn more money than the bond’s coupon. Therefore, in a scenario of rising interest rates, you cannot choose a fixed rate bond because it will cause a lot of volatility and a lot of pain.

As the interest rate increases, you would like to have better coupons than the ones you currently lock in. At the same time, you must also have capital gains.

Variable rate instruments offer you the solution. These are instruments linked to market reference rates. It can be a three month treasury bill, a six month treasury bill or the Mibor rate which is the overnight rate and they offer a spread beyond that.

As the Reserve Bank of India raises the interest rates, the market benchmarks also change and along with a change in the market benchmarks, your coupon changes at regular intervals.

For example, the Indian government issues government securities that are linked to six-month treasury bill rates, and they are issued at different maturities – five years, 10 years, 11 years. When one chooses to invest in such instruments, if the RBI raises the interest rates, the three-month and six-month Treasury bill rates will also rise. Thus, every six months, your coupon is reset upwards.

The beauty of these products is that at present they are quite cheap compared to what is offered by the rest of the market. The spread offered in these products is quite high. For example, a six-year Indian government floating-rate bond offers a spread of nearly 90 to 100 basis points over a six-month Treasury bill. For starters, you’re already getting around 5.5% of your income. If the RBI increases interest rates by 100 basis points over the next year, 5.5% may rise to 6.5%.

The day-to-day index market is already announcing that one year later, the one-year curve would be at 6.5%. So we are already seeing a sharp rise in short-term interest rates over the next year. Therefore, if one invests in this type of instrument, one does not only benefit from higher coupons. Generally, we have found that as the interest rate rises, the overall coupon of these bonds becomes attractive to investors and the demand from all investors also increases.

It’s also possible that the attractiveness that these bonds are valued at right now, that attractiveness could compress, which effectively means that yields may compress. When they compress, you get an extra benefit.

Something that’s available at 100 basis points right now, when interest rates start to adjust to 5.5%, the relative attractiveness from an overall return perspective becomes higher and people will be able to buy at 80 basis points rather than 100 basis points. Not only do you earn the coupon and spread portion, but there are also opportunities for capital appreciation gains in this segment.

Therefore, from all these points of view, they are opportune instruments in a scenario of rising interest rates. Valuations are quite cheap and from a global point of view, compared to all other fixed rate instruments – be it a FD or any other two or three year fixed rate bond – these instruments seem to be the most attractive investment points.

About Jimmie T.

Check Also

NIO Boosts EV Battery Leases and Exchange Stations Across Europe

Chinese electric vehicle automaker NIO has already rooted its flag in European soil, but is …