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RBI Rate Hike Paused: Consider Investing in Long-Term Bonds for Higher Returns

by Tavaga Invest
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Last week the Reserve Bank of India pressed the “pause” button on interest rate hikes. After six consecutive hikes in the past year, this was a surprise and could be a turning point, triggering a status quo and eventual possible rate cuts in the future.

How does it impact investors like you and me and why is it a good time to look at bonds now? Let’s delve into this deeper. But, before that a little explainer of what is a repo rate and how changes in these rates affect us. 

What is the repo rate?

It is the rate of interest at which commercial banks borrow money from the RBI. A higher repo rate increases the cost of capital for these banks. When the repo rate rises: 

  • Banks increase loan rates to cover their borrowing costs, so loans become expensive
  • They also sometimes increase FD rates (albeit not in the same proportion as loan rates) to incentivize depositors
  • New bonds issued will also raise interest rates, known as coupon rates
RBI Repo Rate Trend

What are bonds?

Bonds are debt instruments issued by corporates and governments to investors. Bonds come with a coupon rate (interest rate) and a fixed maturity period. Bonds are tradeable but are less liquid than stocks. A bond held till maturity is a simple investment where you earn a fixed interest and get back the principal at the end of the maturity period. However, it gets tricky for people who want to sell their bonds midway. Due to interest rate fluctuations, the demand and supply forces do not match, making the bond prices prone to interest rate risk. Let’s understand how.

Bonds and repo: how are they connected?

Bonds are sensitive to repo rate changes. When the repo rate rises, the interest rate on bonds rises too – to encourage people to invest in bonds. Otherwise, everyone will opt for FDs which are safer, right?

Bond prices are inversely proportional to interest rates. They rise when interest rates fall and vice versa. as demand and supply forces regulate bond prices.

Now that the interest rates are high, one would naturally want to invest in bonds at the increased interest (coupon) rate, but not necessarily. The investor can buy a newly issued bond that offers a higher interest rate or they can buy an existing bond that offers a lower coupon. 

But, why settle for less?

It may seem obvious for the investor to pick the new bond offering a higher coupon, but it’s not that simple. When repo rates are increased, the demand for new bonds offering a higher coupon will rise, causing them to trade at a premium. 

In this situation, choosing the older bond is better as it has less demand and tends to sell at a discount (trades cheap). These lower coupon bonds often offer a better return on investment (ROI) in the long run, depending on factors like time to maturity and price adjustments.

Time to look at bonds then?

With a consistent hike in repo rates since last year, bond interest rates have also increased. But now with the pause in these hikes has changed the situation to an extent. There is a possibility that rates may not rise much from here or rather may even be cut to protect growth. In case of a rate cut, all new bond issues and FDs will offer lower rates. 

At this juncture, it is advisable to lock in these high rates with existing bonds. For example, the coupon for a 10-year govt bond is 7.26%. So if you invest in this bond, irrespective of what the repo rate is and what the FD rates are, you will keep getting 7.26% every year, till 2033. And in 2033 you will get the face value of the bond back. 

1 year – 2 years6.69
4 years – 5 years7.38
9 years – 10 years7.26
13 years – 15 years7.41
A pictorial representation of bonds and coupon rate

Are long-term bonds the way to go?

Long-term bonds mature after at least 10 years. The lengthier maturity period makes it more prone to interest rate fluctuations making them very price sensitive to interest rates. But if you decide to hold it till maturity then they also offer inflation-beating returns in the long term.

So yeah, if repo rates are reduced going forward, and if economic conditions for India do not get worse over the long term than what it is right now, then it is a good time to invest in long-term bonds and lock your interest!

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