The Hindu Business Line : Long-term bond funds: Exposure driven by interest rate view

Are long-term bond funds, especially gilt funds, optimal investment at this point in time? This article suggests that the decision to invest in bond funds depends primarily on the interest rate view over the investment horizon. The article also discusses how to choose between income and gilt funds.

B. Venkatesh

This column dated February 15, 2009 discussed why bank fixed-deposits are more optimal than short-term bond funds. In response to that article, several readers wanted to know if it is optimal to invest in long-term gilt funds.

This article addresses the question. It discusses gilt funds and the risks associated with bond fund investments. It shows how to decide exposure between income funds and gilt funds. It also suggests that an optimal exposure to bond funds would require investors to take a view on interest rate and credit risk.

Gilt funds vs Income funds

Funds that take exposure to only government bonds are called gilt funds. Long-term gilt funds are those that typically invest in bonds with residual maturity of 10 years and above. Generic bond funds (also called as income funds) take exposure to government and corporate bonds. Both government and corporate bonds are exposed to interest-rate risk.

This is the risk that bond prices will decline because of rise in interest rates (inverse price-yield relationship).

Corporate bonds are also exposed to credit risk. This is the risk that such bonds will decline in price because of widening credit spreads (due to increase in credit risk) and credit rating downgrades. So, corporate bond prices can decline because of rise in interest rate and/or widening credit spreads.

The flip side is also true. If interest rates decline and/or credit spreads tighten, bond funds will generate capital appreciation besides collecting interest on the bonds. Returns could, hence, be higher than that on bank fixed deposits.

But how should an investor decide exposure between gilt funds and income funds? The choice would depend on the view on credit risk.

If an investor expects credit spreads to tighten, she should prefer income funds; for corporate bonds will increase in value when credit spreads tighten.

If credit spreads are expected to widen, gilt funds would be optimal; for widening credit spreads would lead to decline in corporate bond prices.

But the decision to invest in bond funds should be primarily driven by an interest rate view. Specifically, will interest rate increase or decrease over the desired investment horizon?

The benchmark ten-year bond yields declined 1.30 percentage points (or 130 basis points) since March last as a consequence of the sub-prime crisis. It appears that the risk of a rate rise is higher than a rate decline.

Of course, a rate decline will happen only if the sub-prime crisis is tidied and world economy recovers.

It is, perhaps, more practical to state that it would be risky to hold long-term bonds if the investment horizon for a portfolio is more than two years; for interest rates could increase by then.

To appreciate interest rate risk within the context of bond funds, consider a certain fund that had portfolio duration of 7.03 as on March 31, 2009. That means for a 100 basis point increase in yield for all bonds in the portfolio, the market value of that portfolio will decline 7.03 per cent.

Conclusion

There is another factor that an investor has to consider before taking exposure to bond funds — whether investments now can match a liability structure in the future such as a residential mortgage.

Investing in a bond fund to match such a liability structure could expose the investor to price risk.

This is the risk that decline in bond prices at time of redeeming the units could prevent the investor from realising her investment objectives; bank fixed deposit can be easily matched with the liability structure.

If investor is not concerned about price risk, the decision to invest in bond funds is based entirely on the interest rate view.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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