Three Questions to ask to avoid bond mishaps
In last week's Search for Yields newsletter, the free weekly newsletter from INRBonds to help bond advisors and investors alike in investments in bonds and other fixed income investments, we introduced 3 questions to ask to avoid bond mishaps. The questions were :
Will interest rates move up or down in the future?
What will guarantee my principle repayment?
Can I sell the bond if I see a threat to my investment?
We will dwell upon the first question, will interest rates move up or down in the future.
Why is the outlook for interest rates important for bond investments?
In very simple terms, bond prices move in inverse proportion to interest rates. If interest rates rise, bond prices fall and if interest rates fall bond prices rise. When bond prices fall and you go to sell the bond, you will face capital loss and when bond prices rise you will have capital gains when you sell the bond.
You may ask now that if you plan to hold the bond till maturity and not planning to sell the bond, why should interest rate movements matter? It will matter even if you are a hold to maturity investor, as you will miss the opportunity of investing at higher interest rates if outlook for interest rates are higher and you will miss opportunity to lock into higher rates when outlook for interest rates is lower.
Other relevant points are that if interest rates rise substantially, the credit quality of the bond you hold may deteriorate when borrowing costs rise. If you have better opportunities for investments or if you need funds earlier than anticipated, selling bonds at higher interest rates will cause capital loss.
What is the current outlook for interest rates, will it rise or fall?
RBI has cut repo rates to record lows of 4% and with inflation at well above 6%, the scope for further rate cuts look low. However, with economic growth hit by covid, RBI is not in a hurry to raise interest rates, as it wants to improve growth. If growth does improve on low interest rates, then inflation could pick up in the future and this will lead to interest rates rising in the economy.
