This article discusses exposure to bond funds, money market funds and term deposits in the fixed-income space. It shows why retail investors who hold the view that interest rates will harden a year hence are better off with term deposits or money market funds.
Most investors want to increase their exposure to fixed-income securities, given the high downside risk in stocks. Several posed us this question: Are bond funds good investments now, even if interest rates increase after a year? Or are bank fixed-deposits a better choice?
This article discusses the risks associated with bonds and bond mutual funds. It shows why term deposits and money market funds may be optimal investments for retail investors who are more concerned about interest rates going up a year hence.
Bond market structure
Bonds carry an inverse relationship with interest rates. When interest rates go up, bond prices come down and so does the net asset value (NAV) of a bond fund.
The sensitivity of bonds to interest rate changes vary with maturity. A long-term bond (maturity of more than 10 years) will be more sensitive to interest rate changes than a short-term bond (maturity between one and five years).
It logically follows from the inverse price-yield relationship that investors who expect interest rates to go up, should hold funds that invest in short-term bonds, for such bonds carry low interest rate risk. And investors who expect interest rates to decline should hold funds that carry long-term bonds, for such bonds will generate higher returns.
The problem, however, is that interest rates are not market determined as stock prices are. Reserve Bank of India (RBI) along with the Government tightly controls interest rates in the economy. This means that market participants may not necessarily have diverse opinion on rates.
Besides, investors are not allowed to set-up short bond positions to take advantage of their view that interest rate will increase a year hence. At best, investors can take long exposure to short-term securities now and switch to their preferred investment after interest rate moves up. It is in this context that a retail investor has to choose from short-term funds, money market funds and bank deposits.
Bonds funds Vs Bank deposits
Short-term bond funds would be appropriate if the investor can liquidate her units just before interest rates move up and reinvest the proceeds in higher interest-bearing instruments.
But given that the RBI controls interest rates and that market participants do not typically have a diverse view, timing the bond market may be difficult. Besides, the high volatility in interest rates exposes short-term bond funds to price risk — the risk that the NAV will decline in value when the investor decides to redeem.
Money market funds typically take exposure to commercial papers, certificate of deposits, call money and treasury bills – instruments with maturity less than one year. These funds are the least sensitive to interest rate changes. They, however, carry higher reinvestment risk — risk that the fund may have to reinvest the proceeds at a lower rate in the future due to decline in interest rates then.
As reinvestment risk is currently low, investors can consider money market funds for short-term exposure. It would be optimal to choose funds that carry higher exposure to treasury bills, call money and certificate of deposits.
But what about term deposit with banks? If the investor matches the deposit maturity with the investment horizon (say 14 months), the reinvestment risk is minimal. Moreover, there is no visible price risk as deposits are not traded in the market.
These investments instead carry inflation risk — the risk that increase in inflation would bring down the purchasing power of the deposit on maturity. But as inflation risk does not seem to be of much concern now, investors could also consider term deposits for short-term exposure.
It is important to understand that term deposit and money market funds are optimal choices when the investment objective is to enhance cash returns till interest rates move up. The advantage is that an investor need not worry about price risk at redemption, as she has to in the case of bond funds.