The hardening interest rate climate in the country triggered by the Reserve Bank of India’s monetary measures this July is still some distance from settling down. With the rupee depreciating significantly against the US dollar, the RBI increased the Bank rate from 7% to 8% effective July 21 and the cash reserve ratio (CRR) by 0.5 percentage points to 8.5% -- the CRR increase was in two phases of 0.25% each on July 29 and August 12. The policy changes announced by RBI have become a cause of concern in the Debt funds market in India. The various factors, which have made the hike inevitable, are :

Demand-Supply Mismatches: Inflows from foreign institutional investors (FIIs) have been lower so far this year compared to trends in 1999-00. Between April and July 1999, net investments by FIIs in the Indian markets were around $1bn. But in the same period during this financial year, net FII investments were only $0.13 bn. FII investments have been declining consistently from April 2000. Higher than expected economic growth in the USA leading to expectations of a rate hike by the US Federal Reserve Board in August, probably prompted the FIIs to repatriate a portion of their investments from markets in emerging economies. Further the Rupee/Dollar volatility in May and July 2000 could also have led to the diminishing of FII interest in the Indian market. FIIs appear to have adopted a wait-and-watch policy, deferring their investment decisions.

Let us now look at the effect of the rise in interest rates on the investor and on fund managers.

On the investor’s front there is always the question of Why own bonds at all. Long-term return on stocks is significantly higher than the long-term return for bonds. But even if long-term bond returns fall short of stock returns, they do provide a useful asset class for investors, allowing investors to diversify their investment portfolios. At a minimum, bonds will moderate the volatility of an investment portfolio.

At the same time, short-term bonds offer a wonderful yield premium relative to cash reserves, in exchange for only a small increase in principal risk. The principal risk for the Treasury bonds comes from the possibility of changing interest rates.

It's only a small step from bonds to bond funds, which offer broad diversification, mitigating the substantial risk that can easily haunt an investor who owns a single bond that goes into downgrade or default. Bond funds also maintain a constant maturity rather than one that gradually shortens as the day of maturity approaches, as would be the case if an investor purchased a bond directly.

The case for bond investing is strong, both for equity investors seeking to reduce portfolio risk and for money market investor seeking to enhance income with only a modest increase of risk.

Investors in the debt markets tend to follow one of three kinds of investment programs. The first set of investors is those who live off the income--the conservative, quality-conscious, income-oriented investors who seek to maximize current income. In contrast, speculators, or bond traders, have a considerably different investment objective: to maximize capital gains, often within a short time span. This highly speculative investment approach requires considerable expertise, as it is based almost entirely on estimates of the future course of interest rates. And finally, there are serious long-term investors, whose objective is to maximize total return--from both current income and capital gains--over fairly long holding periods. In order to achieve the objectives of any one of these three programs, an investor needs to adopt a strategy that will be compatible with his or her goals.

On the fund manager’s front, managing portfolios is a far from easy task. Professional money managers use a variety of techniques to manage the multimillion-dollar bond portfolios under their direction. These vary from passive approaches, to semi-active strategies, to active, fully managed strategies using interest-rate forecasting and yield-spread analysis. Most of these strategies are fairly complex and require substantial computer support. Some of the investing strategies used by fund managers are

Passive investment strategies are characterized by a lack of input regarding investor expectations of interest rate and/or bond changes. Further, these strategies typically do not generate significant transaction costs. A buy-and-hold trading strategy is perhaps the most passive of all investment strategies; all that is required is that the investor replaces bonds that have deteriorating credit ratings, have matured, or have been called. Although buy-and-hold investors restrict their ability to earn above-average returns, they also minimize the deadweight losses represented by transaction costs.

One approach that's a bit more active than buy-and-hold and is popular with many individual and institutional investors is the use of so-called bond ladders wherein an equal amount is invested in a series of bonds with staggered maturities. Here's how a bond ladder works: Suppose an individual wants to confine her investing to fixed-income securities with maturities of 10 years or less; she could set up the ladder by investing in (roughly) equal amounts of say, three-, five-, seven-, and 10-year issues. Then, when the three-year issue matures, the money from it (along with any new capital would be put into a new 10-year note. The process would continue rolling over like this so that eventually the investor would hold a full ladder of staggered 10-year notes. By rolling into new 10-year issues every two or three years, the investor can do a kind of dollar cost averaging and thereby lessen the impact of swings in market rates. Actually, the laddered approach is a safe, simple, and almost automatic way of investing for the long haul--indeed, once the ladder is set up, it's followed in a fairly routine manner. A key ingredient of this or any other passive strategy is, of course, the use of high-quality investment vehicles that possess attractive features, maturities, and yields.

The forecasted interest rate behavior approach is highly risky, because it relies on the imperfect forecast of future interest rates. It seeks attractive capital gains when interest rates are expected to decline and the preservation of capital when an increase in interest rates is anticipated. The idea is to increase the return on a bond portfolio by making strategic moves in anticipation of interest rate changes. Such a strategy is tantamount to market timing and as a result, carries with it some definite risks and costs. An unusual feature of this tactic is that most of the trading is done with investment-grade securities, since a high degree of interest rate sensitivity is required to capture the maximum amount of price behavior. Once interest rate expectations have been specified, this strategy rests largely on technical matters. For example, when a decline in rates is anticipated, aggressive bond investors will often seek to lengthen the maturity (or duration) of their bonds (or bond portfolios). The reason: longer-term bonds rise more in price in response to a given drop in rates than do their shorter-term counterparts. At the same time, investors look for low coupon and/or moderately discounted bonds as this adds to duration and increases the amount of potential price volatility. These interest swings are usually short-lived, so bond traders try to earn as much as possible in as short a time as possible. Margin trading (the use of borrowed money to buy bonds) is also used as a way of magnifying returns. When rates start to level off and move up, these investors begin to shift their money out of long, discounted bonds and into high-yielding issues with short maturities. In other words, they do a complete reversal. During these periods when bond prices are dropping, investors try to earn high yields and protect their money from capital losses. Thus, they tend to use such high-yield, short-term obligations as Treasury bills, money funds, short-term (two- to five-year) notes, or even variable-rate notes.

The RBI’s primary concern now is to manage exchange rate movements and ensure orderly conditions in the market, even at the cost of temporary monetary tightening. The large borrowing requirement of the government and an expected pick-up of credit from the industrial sector is likely to lead to a further increase in interest rates, especially in the second half of the financial year.

Deepak V Kuriakose