Surging policy rates and bond yields threatening portfolio valuations?

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The big money is not only in buying or selling, but also in waiting.

- Charlie Munger

In my last piece, I had briefly explained how interest rates and inflation are interdependent and drive major decisions of the economy on a macro level. Zooming into the implications of these on wall street (dalal street), this piece is intended to crack two major codes. First, what impact do the increasing benchmark policy rates have on companies' cost of capital, and second, how do surging sovereign bond yields pose a threat to debt and equity valuations.

Policy rates tend to pull up the cost of capital/cost of borrowing for firms, trimming their margins considerably. The sectors worst hit include banking, automobile, and realty. With EMIs getting expensive and loan interest rates rising, the demand for debt is impacted, and going forward a strain can be foreseen on that end.

In my last piece, I had also projected how the interest rate regime is on the rise, and it has only started. So what should be the recourse for you as an investor? With bond yields shooting up, and another hike expected this quarter, should you shy away from debt funds? When bond yields rise, their prices begin to fall. Why? Simply because a better product (in this case a higher yield bond) is available in the market, bringing down the value of the existing (lower yield) bonds that you may be holding. Thus, rising yields result in mark-to-market losses for debt mutual funds and SIPs.

What essentially needs to be managed here is the time horizon. This aspect will play a pivotal role in determining whether your portfolio is in green or red. If we look at terms like 6 months, looking at short-term debt funds with rising yields will give you the flexibility to bail out and help book gains.

Investing in shorter maturities provides you with some immunity to interest rate fluctuations as compared to longer maturities. Say today the 10-year bond yield is at 7.4%. With the next interest rate hike by the Central Bank, it rises to 7.8%. This will bring down your existing bond’s price, so you lose in terms of valuation (I will get back to this in a bit) and again you are stuck with bonds with a locked-in interest rate that is lower than the current market levels and you will be paid 0.4% lower with every coupon payment.

Choosing a shorter maturity bond vs a longer maturity bond when interest rates are rising. What to do?

When the policy rates are rising (what we are essentially witnessing right now), the bond yields are also expected to go up. This rule applies to short-term and long-term bonds. However, which one of these sees more volatility? Bonds with longer maturities see higher volatility. Their yields consist of the following components- Policy risk-free rate, duration risk premium (the incremental expected return investors demand for bearing duration risk), and expected inflation. The duration risk premium or the term premium fluctuates more for long-term bonds. The probability of interest rates rising is higher in the longer term. Moreover, duration measures the sensitivity of bond prices to changes in interest rate. For instance, a bond with 3 years of duration, will decrease by 3% every time the interest rate increase by 1%. So for higher maturities, the sensitivity to bond prices is even higher and the overall impact on long-term yields is higher when interest rates are rising.

When analysts predict the peaking out of the rising interest rate regime, that is, some stability and recourse can be expected, that would be a better time to start thinking about longer maturity bonds.

So what about the equity investments?

A general concept behind equity valuations is discounting future cash flow to present value. The value of equity is broadly the current equity capital plus the sum of expected free cash flow discounted to its present value. This discounting is done using the risk-free rate or the policy rate (which is on the rise!). So when this rate rises, the discounted present value falls, bringing down equity valuations too. This along with rising cost of capital and shrinking margins is impacting stock values throughout.

How do you protect your portfolio? Two key aspects here- do not put all your eggs in one basket. The infamous rule that diversification is key, needs to be applied. Alternative assets/investments that prove to be inflation hedges should be kept in mind. Also, hurrying out of long-term funds only to book a capital loss does not solve this either. On one hand, there is still some scope for 10-year yields to rise, and on the other, even though the repo rate hike has just started, the 10-year yield curve is already ahead of the market because it has been going up consistently since last year. The historical charts show that it has risen up to a max of 7.8% and right now we are already at 7.4%. Making gradual changes to rebalancing the portfolio seems to be the best idea when we are talking about these asset classes.

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