After Silicon Valley Bank revealed large losses on its US bond portfolio that had eaten into its capital, there’s been a lot of social media outrage. Some folks are shocked that banks can make losses on a cast-iron investment such as US treasuries. Others seem to be appalled that Silicon Valley Bank is not alone and that many other global banks are in the same boat. This shows that investors at large have only a vague understanding of what rising interest rates do to bond portfolios.
You have also been bombarding us with questions on how interest rate risks can play out for debt funds, particularly target maturity, constant maturity and gilt funds. We try to address them here.
Q. How can government bonds make losses? Are they not the ultimate safe haven investment?
When you lend to anyone, there are two types of risks you take. The first risk, well known to everyone, is that the entity you lend to, refuses to repay interest or principal. This is default risk, also called credit risk in finance. But bonds issued by good governments from stable economies seldom carry credit risks.
Today though, government bonds are seeing a second kind of risk play out. When interest rates in the economy rise, the prices of older bonds in the market tumble leading to losses on bond portfolio. The logic for this is simple. If I bought a one-year bond at a face value of Rs 100 with a coupon (interest) of 7% a week ago and today, market interest rates rise to 7.5% (because the central bank hiked rates), then new investors will no longer be willing to buy my bond at the price I paid for it. After all, bonds carrying a higher interest rate are now available in the market. To get investors to buy, I’ll have to lower my selling price. This is interest rate risk.
The US Fed has hiked policy rates from 0% to 5% in the last nine months. As banks tend to be largest holders of government bonds, their treasury holdings are today worth far less than what they paid for them. This is how SVB and other banks have managed to make losses on ‘safe’ gilt portfolios.
The thing to understand here, is that the fall in market prices of government bonds due to rising rates, does not make them ‘unsafe’ in the traditional sense. Governments including in the US will repay their principal obligations in full on maturity. But if you want to sell these bonds before maturity in the secondary market, then you can only sell them at a discount. This is how interest rate risk hurts bond holders.
Q. Why are long-term bonds and long-duration funds dented more by interest rate increases, than short-term bonds or short duration funds?
The longer the tenure of the bond, the higher the opportunity loss of staying locked into lower rates. If you bought a 10-year bond paying a 7% coupon, and market rates rise to 7.5% soon after, you will have to forego the extra 0.5% in interest for the next ten years. But if you bought a 1-year bond, you forego that extra interest only for one year, after which you can jump to bonds with better rates. This is why when rates rise, prices of long-term bonds in the market suffer bigger declines than short-term bonds.
To illustrate, assume you hold a 1-year bond bought at Rs 1000, with a 7% coupon and the market yield rises to 7.5%. Theoretically, the market price of your bond will now fall to Rs 995.3, because this is the price at which its yield will equal newly issued bonds. But if you own a 10-year bond with the same coupon and the market yield rises to 7.5%, this will see its market price fall much more, to Rs 965.3. While a 0.5% rise in rates leads to a roughly similar loss on a one-year bond’s price, it triggers nearly a 3.5% fall in the 10-year bond’s price.
The higher discount compensates new investors for the opportunity loss on interest for the many years left to maturity. This is why in a rising rate scenario, long-duration and medium duration debt funds suffer bigger NAV losses, compared to ultra-short, low or short duration funds.
Q. If I bought 5-year or 10-year g-secs when market interest rates were lower, will I need to take a loss on maturity?
No, you will not. If you hold your g-secs to maturity, you will get back the purchase price you paid. You would also have received interest pay outs at the rates you originally expected. If you invested Rs 1000 in a g-sec maturing in 2032 at a 7% yield and the market yield spiked to 7.5% after this, you will continue to receive interest of Rs 70 annually, and will get back your principal of Rs 1000 in 2032 when the bond matures. But if you try to sell this bond in the secondary market today, you will need to sell at a discount to Rs 1000.
This brings us to a key difference between credit risks and rate risks in debt investing. While credit risks arising from an entity being unable to repay your money, are often permanent losses, rate risks arising from interest rate movements usually represent notional losses. In the above example, the difference between the yield you earned on the bond (7%) and the market yield (7.5%) is an opportunity loss to you, but it is not a permanent capital loss.
Applying this logic to debt funds owning long-term bonds, can help you view rate risks with greater equanimity. When interest rates in the market move up, bonds in long-duration fund portfolios may get marked down, leading to NAV losses. But if these funds hold their bonds to maturity, they will get back their principal even as they accrue interest at the initially expected yield.
If you panic and exit long-duration debt funds after rising rates have dented their NAV leading to poor returns, you will be giving up on the chance to make up these notional capital losses through interest accruals and principal repayment on maturity. If you hang on, interest receipts and maturity proceeds in these funds will eventually improve their returns. And let’s not forget that bond prices like stock prices, follow cycles. So, if you hold on to the fund long enough, bond prices will recover again to erase your NAV losses.
Q. How can I minimise rate risks in my portfolio?
The best way to reduce rate risks in your debt portfolio is to own bonds or debt funds that have short maturities. Liquid funds, ultra short debt funds, low duration funds and money market funds in India, for example invest mainly in securities with maturities ranging from 91 days to 12 months. These categories of funds are less vulnerable to rate risks because even if market interest rates were to rise sharply, they will see their portfolios reset to higher yields quickly.
Q. Why shouldn’t I shift my entire debt portfolio into very short duration funds and bonds?
Owning only short-duration bonds or funds in your portfolio can significantly reduce your returns. Under normal market conditions, money market instruments, treasury bills, commercial paper and other short-term instruments tend to offer low yields compared to long-term instruments such as corporate bonds, PSU bonds, g-secs, State Development Loans and so on.
The difference between 1-year bonds and 10-year bonds can be as much as 300-400 basis points. It is normal for issuers to offer higher yields on long-term bonds, because as you stretch your tenure you are taking on added uncertainties relating to the entity borrowing the money, likely trends in inflation and interest rates in the economy over an extended period.
Therefore, to earn good debt returns, investors need to strike a balance between owning short-duration bonds/funds to avoid rate risks, and owning long-duration bonds/funds with higher yields. To make sure that rate risks do not affect you much, you can match the average portfolio maturity of the bonds or debt funds you are buying with your own goals and intended holding period. At PrimeInvestor, this is the reason why we classify our recommended list of Prime Funds in time-frame based buckets rather than just the category!
Q. Do Target Maturity Funds and Fixed Maturity Plans solve the rate risk problem?
Yes, to an extent. Fixed Maturity Plans (FMPs) are close-ended debt funds that come with a fixed end-date. They only buy and hold bonds that are likely to mature on the same date as the fund itself. This shields investors in FMPs from rate swings in the intervening period.
Target Maturity Funds (TMFs) are open-end funds that follow a somewhat similar strategy. They set a specific end-date for redemption and own a mix of bonds (usually PSU bonds, SDLs and g-secs) that will all mature on the target date. However, their open-end structure allows new investors to enter the fund anytime after launch, while older investors can sell out. TMFs try to manage this churn by shortening the tenures of the bonds they own as their target date approaches.
So, a TMF maturing in 2027 will today be invested in bonds with 4-year maturity, but next year the maturity will shrink to 3 years – both from existing papers rolling down in maturity and fresh inflows being deployed in line with the residual maturity period. This is called a roll-down strategy.
Strategies of TMFs and FMPs make it somewhat easy for investors to gauge their likely returns from their funds if they hold until the target date. The returns will roughly correspond to the fund’s current portfolio yield-to-maturity (YTM) minus its expense ratio. But to earn the indicative YTM, it is essential to hold such funds until their maturity date.
Q. Why does PrimeInvestor recommend specific TMFs like the ones maturing in 2027, but not others maturing in say, 2028 or 2030?
Under normal market conditions, the longer a bond’s tenure, the higher the yield it offers. But sometimes, distortions in variables influencing rates, such as liquidity, policy actions and government borrowing intentions, skew this equation. These distortions offer opportunities for bond investors to benefit from anomalies in the yield curve.
Recently, for instance, we saw an unusual situation where 364-day treasury bills, 5-year g-secs maturing in 2027- and 10-year g-secs maturing in 2032, all offered similar yields of about 7.3%. When the yields available for shorter tenures match those on long tenures and there is a likelihood of a further rise in rates, it is prudent not to stretch your duration too much. This is why we found value in TMFs maturing in 2026-27, compared to other tenures. Read our recommendation on this here.
Q. Why did PrimeInvestor recommend 10-year constant maturity funds, when there are rate risks? I find that these funds have returns only 2-3% in the last six months though 10 -year g-sec was yielding 7.4-7.5% at the time of the recommendation.
We try and recommend 10-year constant maturity gilt funds when we feel that 10-year gilt yields in India are close to their peak. This helps investors earn a good combination of high interest accruals with relatively low rate risk.
With yields on treasury bills spiking to 7% plus, it is true that low duration and money market funds did offer attractive investment opportunities. But if you are an investor looking to park debt money for long-term goals such as retirement or children’s education, investing in very short duration debt funds will not serve your purpose because such funds can see their returns dip, when market interest rates fall from current unusually high levels.
We have observed that over the last three decades, interest rate cycles in India top out at levels of about 8% (the peak could even be lower this time, given growth concerns). Read why we think so here in our Debt outlook for 2023.
Therefore, when market yields hit levels of 7.5% plus, we see this as a good opportunity for investors to lock into constant maturity gilt funds for their long-term debt holdings. Yes if you check on the NAV performance of these 10-year constant maturity funds a few months after buying them, your returns may not correspond to the YTM at which the fund was recommended. This is because interest rates, like stock prices tend to swing either way in the short run.
Over time though, the steady pace of interest accruals on 10-year g-secs will smooth out the returns on these constant maturity funds, so that your final returns at 10 years, will roughly correspond with your initial YTM.
And for medium to long duration funds in general, depending on how well the funds are able to book profits on rate falls (causing capital appreciation), returns can be better than the yields you entered at.
But to curb the short-term volatility that these longer duration funds cause, we usually recommend mixing them with some short term debt funds in your portfolio. You will see this in our Prime Portfolios as well as Build your own portfolio tool.