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Time to invest in bonds?
Let's discuss RBI's rate hike pause!
Okay, so last week if you read the papers, you would have seen that RBI “paused” rate hikes (and well if you didn’t read it, we’ll talk about it today, don’t worry 😁)
Let’s see in 5 minutes what that means and how it impacts you. And whether it’s a good time to invest in bonds now.
First, what does the rate hike pause mean?
Well, RBI has been increasing the repo rate (commonly known as interest rate) since a while now. But recently, they took a pause. This means that they are not going to change interest rates, at least for a while, till the situation of the economy changes (i.e improves or worsens, hoping for the former).
Okay, what impact will this have on us?
I’ve explained the impact of repo rates on the country in a separate article (which you can read, I’ll link it in the related reads section). But let’s quickly summarise how it works:
Increase in repo rate means cost of borrowing for banks increases
This means that loans get more expensive for you. And it also means that FDs give better interest
Most importantly, new bonds that are issued by government entities or public/private corporations, will also give better interest (known as coupon - this is what bond interest is technically called).
And this is where the game changes.
Now, imagine you want to invest in bonds, and RBI just recently increased the repo rate.
So you can either invest in new bonds that have got issued after the rate hike, which will give a higher coupon; OR you can invest in existing bonds that are giving a lower coupon.
The obvious choice here is to invest in new bonds, right?
Well, not always.
You see, since new bonds will give a better coupon, the demand for old bonds will be lesser. This means that they will now be available at a cheaper price. So investors may choose older bonds too instead of the newer ones because they’re available for a low price, so the ROI could be higher, depending on how the price gets adjusted, maturity period of the bond etc.
Phew! If you understood this, you’ve won half the battle!
Now let’s see how RBI rate hikes affect long term bonds.
Long term bonds and RBI rate hikes
So, bonds are issued with various maturity periods.
[Maturity period is that time till when the bond will pay you the coupon. So, in a typical scenario, if today a bond is launched with a 5-year maturity period and you invest in it, you’ll keep getting the coupon for 5 years, after which the face value of the bond will be given to you]
Now, if you opt for a longer maturity period bond, say, 10 years, this means that your exposure to repo rate hikes is longer (there are higher chances of repo rate changing over 10 years than over 1 year, right?)
So if you invested in a bond and held it till it matures, it’s all good. Because you invested an X amount for Y% coupon and at the end of the maturity period, will get the face value of Rs. Z. All these numbers are known when you invest for a time horizon equal to the maturity period of the bond.
But if you want to sell the bond before it matures, what do you do?
Just like stocks, bonds also are traded between companies and individuals. So you can sell the bond to a corporate or an individual investor.
The tricky part is this - If you purchased, for example, a 10-year maturity bond, and 3 years after you purchased it, the repo rate increased. This means that new bonds issued after this repo rate hike will offer a higher coupon (remember?)
Now 6 months after this, if you want to sell your bond, people won’t want to buy it (because obviously, the newer bonds will give better coupon). So you’ll have to sell it at a discount. And depending on the demand and overall market conditions, this discount could be big or small.
So irrespective of what price you paid for the bond, you’ll get a different price for it when you sell it.
Unpredictable, right? That’s what we call Interest rate risk.
Now finally, let’s connect the dots and see how the rate hike pause can benefit you.
Benefits of investing in long term bonds
Since long-term bonds are risky, they generally give a high coupon anyway.
And now, because repo rate is high, the coupon you’re getting for bonds is higher.
Now, imagine that RBI doesn’t change repo rates. The prices of the bonds will remain more or less the same.
But here’s the thing - if the economy gets better, and RBI reduces the repo rate, newer bonds will also reduce their coupon. But you’re holding bonds that were issued earlier, which are offering a higher coupon. So your coupon will be higher than the ones newer bonds are giving.
And, thanks to a higher coupon that your bond is offering, it will be more in demand and the price of your bond will increase. So if you wish to sell it, it’ll fetch you a better price!
Of course, the price and coupon are adjusted, and the value for one factors in the value of the other. But eventually, if you’re holding a long-term bond right now and repo rates reduce, you’re going to be in a sweet spot! 😃
For example, the coupon for a 10-year govt bond is 7.26%. So if you invest in this bond, irrespective of what FD rates are 5 years later, you will keep getting 7.26% every year, till 2033. And in 2033 on the maturity date, you’ll get the face value of the bond back.
So yeah, if repo rates are reduced going forward, and in the next 10 years, the economic scenario doesn’t get worse than what it is right now, this is a good time to invest in long-term bonds and lock your interest!
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Have a lovely Sunday!