Strategies to Optimize Investments During Falling Interest Rates

Falling Interest Rates: Don’t just chase the duration, there is more to it…

With the policy rates being close to their peaks and expectations of the next move being a rate cut, investors are chasing funds with maximum duration to capture the MTM gains driven by expected rate cuts.

While the higher duration of the portfolio helps to outperform in a falling rates scenario, it is not the only factor investors should consider while choosing an MF scheme to maximize their gains from expected rate cuts. In this write-up, we discuss other factors investors might want to evaluate while targeting gains from future rate cuts.

In our view, apart from the higher duration fetching higher gains, three other themes typically play out during the rate cut cycles. Let us evaluate each of them:

    I) Steepening of the Yield Curve
This is the most prominent theme that plays out during the rate cut cycles. Once the funding cost starts moving lower, the impact is reflected more in shorter segments, while the longest end of the curve moves less during rate cuts as it already has rate cuts priced in ahead of the actual moves. Also, once the rate cuts begin, there is a general bias to shift away from duration in favour of shorter segments to reduce volatility while focusing on stable carry income.
The chart below shows the steepening trend between 10- and 30-year G-sec during the last four rate cut phases spanning the past two decades. The spread between 10- and 30-year G-sec widens between the start and end of a rate cut cycle (notified by red arrows).

Source: Bloomberg

The typical dilemma for a cash-constrained investor is whether they should target maximum duration to capture the rate cut cycle or focus on a steepening theme by moving to relatively lower duration. In such cases, decisions can be made by assessing the depth of the rate cut cycle. If the rate cut cycle is expected to be deep, the absolute gains made on a higher duration portfolio can more than offset the sacrifice made due to the steepening of the curve. However, if the cut cycle is expected to be shallow, payout for the shorter segment—due to steepening of the curve—can far outweigh the impact of lower duration in the portfolio.

In the current backdrop, considering that the rate cut cycle is expected to be shallow, relatively shorter to moderate duration strategies may yield higher benefits compared to the sacrifice made due to lower duration in the portfolio.

    II) Widening of the Bond Swap Spreads
Bond yields are determined by a combination of factors such as demand/supply balance, illiquidity premia and policy rate expectations. Overnight Interest Rate Swaps (OIS), on the other hand, are collective market expectations on average policy rates over the tenor of the OIS and hence effectively a pure play on future rate expectations.

Overnight Interest Rate Swaps typically trade below bond yields as it does not have any illiquidity premia, demand/supply constraint, etc. Hence, in case of any policy rate move (up or down), OIS leads the move compared to the bonds. In the early part of rate cut cycles, OIS yields move lower at a faster pace when compared to bonds, resulting in better performance of the former compared to the latter.

The chart below shows the spread between five-year G-sec and five-year OIS during the last four rate cut cycles spanning the past two decades. The spreads between G-sec and OIS increase during the early part of the rate cut cycle (notified by red arrows). Also, during three out of four cut cycles, the spread between G-sec and OIS crossed 100 bps while on the remaining one cut cycle, the spread ruled above 80 bps. This contrasts with the current spread of 60 bps, indicating that the potential for OIS to outperform is high once the rate cut cycle begins.

Source: Bloomberg

To benefit from a reduction in policy rates, it is worth having some duration exposure by going long in OIS* (receive fixed OIS against an underlying). Any rate cut is expected to reflect faster in the OIS yields and may yield superior returns when compared to a 100% bond-only portfolio.
* A receive fixed/long position in OIS benefits when interest rates move lower.

    III) Widening of Spreads for Floating Rate Bonds
When the rates are expected to drift lower, investors prefer to lock their money into fixed-rate securities so that there is no impact of rate cuts on their future accrual income. Hence, demand for floating rate bonds may fall as no one wants their future cash flows to fall during the rate cut cycle. This may result in the widening of spreads for floating rate bonds due to reduced demand for such bonds during the rate cut cycle.

To see detailed calculations showcasing the widening of spreads on floating rate bonds, please refer to Annexure 1.

Key strategic insights 
While the desire to chase a maximum duration portfolio is justified on the part of investors, one should also pay due attention to the other three factors:
    • having a portfolio tilted towards the relatively shorter end of the yield curve to benefit from steepening
    • having some long exposure to OIS to benefit from the widening of bond swap spreads
    • avoiding strategies that rely heavily on floating rate bonds
While focusing only on duration may look like a winning strategy in the short term, a more disciplined approach to investing will require investors to focus on every finer aspect of the yield curve/asset class movement rather than grossly relying on the portfolio duration alone.

Annexure 1

Factors explaining the widening of spreads on floating rate bonds

Another way to explain the widening of spreads of floating rate bonds is by looking at how floater papers are priced. The coupon of any floater paper is expressed in terms of a floating benchmark plus a fixed spread. In the case of a fixed rate bond, movement in market interest rates results in price movement of the fixed rate bond. However, in the case of a floating rate bond, the price movement is triggered by a movement in the market spread on comparable synthetic floaters.

Let us understand the correlation between synthetic and normal floaters in detail:

A synthetic floater position is created by combining a fixed rate bond and Overnight Interest Rate Swaps (OIS). In an arbitrage-free world, adjusted for illiquidity, the yield on a normal floater should be equal to the yield on a synthetic floater. Hence:

Synthetic Floater =	Original Floater
Fixed rate GSEC yield – OIS yield =	Original floating rate GSEC yield
Yield on 7.37% GoI 2028 – 2028 maturity OIS yield =	GoI FRB 2028 Yield
6.96% – (6.36% – Mibor) =	6 month TBill + 0.57%
6.96% – (6.36% + Mibor) =	6 month TBill + 0.57%
Mibor + 0.60% =	6 month TBill + 0.57%

 

Considering that the long-term median spread between daily Mibor and 6-month T-bill yield has been 0.17%, this spread has been further lowered to negative during rate cut cycle (refer to the chart below). The Mibor, however, is compounded daily, which results in effective Mibor being roughly 18 to 20 bps higher. Hence the effective Mibor can be assumed to be almost equal to the 6-month T-Bill yield.

Considering that effective Mibor and 6-month T-bill yield are approximately the same and get cancelled out on both sides of the above equation, the spread on the Synthetic Floater comes closer to the spread on the Normal Floater. However, since both legs of the Synthetic Floater (Fixed Rate G-sec and OIS) are highly liquid when compared to a Normal Floater, the spread at which Normal Floater trades will have an illiquidity premia over and above the spread of the Synthetic Floater. This illiquidity premia will be dictated by the buyer’s degree of preference for liquidity.

We have already discussed in the paragraph on bond swap spreads how OIS leads the move, compared to bonds, during the rate cut cycle. Hence, in the above equation, the spread between fixed rate G-sec and OIS fixed yield increases due to a sharper move down in OIS, resulting in a higher spread on the Synthetic Floater. This will force the spread on Normal Floater to also move up, triggering underperformance of floating rate bonds during the rate cut cycle.

Source: Bloomberg

The views expressed are the author’s own views and not necessarily those of UTI Asset Management Company Limited. The views are not investment advice and investors should obtain their own independent advice before taking a decision to invest in any asset class or instrument.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.