Bond Investments - Break-even rate and maturity mapping

This article shows why investing in bank fixed deposits with the highest interest rate may not always be ideal and reiterates the importance of choosing maturity based on the individual's investment horizon.

That the NHAI bonds closed for subscription early is a standing testimony to the investor interest in bonds as an asset class. As individuals typically tend to hold bonds (including bank fixed deposits) till maturity, the only source of return from such investment is interest or income return. The question is: How should individuals select bonds and bank fixed deposits so as to make such investments ideal within their portfolio structure?

This article explains the relevance of break-even rate analysis in bond investments. It then shows why investing in bank fixed deposits with the highest interest rate may not always be ideal and reiterates the importance of choosing maturity based on the individual's investment horizon.

CHASING RATES?

Consider the NHAI bonds. The bonds were offered in two variants — the 10-year bond with an interest rate of 8.2 per cent, and the 15-year bond with an interest rate of 8.3 per cent. To many, the 10-year bond seemed attractive. After all, most would have reasoned, a 10 basis-point increase in interest rate isn't a good compensation for locking-in money for an additional 5 years.

We, however, urge investors to look at such investments in a different way. Consider two scenarios. In scenario I, assume that an individual buys the 15-year bond and earns 8.3 per cent every year till maturity. In scenario II, the individual buys the 10-year bond, earns 8.2 per cent for 10 years and then reinvests the capital for another 5 years. In both cases, we are assuming an investment horizon of 15 years.

The investor would be indifferent between scenarios I and II, depending on the rate that the 5-year bond earns between years 10 and 15. Suffice it to know the break-even rate to make the individual indifferent between the two scenarios is 8.5 per cent. This means that the individual should expect to earn 8.5 per cent or more on a five-year tax-free bond 10 years hence, to prefer the 10-year bond today! And if an individual is willing to lock-in to 8.2 per cent rate for a 10-year bond, expecting 8.5 per cent for a 5-year bond, 10 years hence seems somewhat far-fetched.

WEALTH MAPPING

Notwithstanding choosing bonds based on break-even rate, individuals should invest in a maturity that closely matches their investment horizon.

An individual having a 10-year investment horizon should prefer the 10-year bond, even if the 15-year bond carries attractive interest rate. Alternatively, an individual may have 10-year and 15-year investment horizon because of two different goals. Based on the break-even analysis, the individual may invest only in the 15-year bond, and choose some other 10-year bond to map the 10-year investment horizon. Or she may choose to invest in both bonds of NHAI, if she finds its 10-year bond more attractive than other 10-year bonds available in the market.

The above argument holds true for bank fixed deposits as well. We recently noticed several banks nudging customers to invest in one-year deposit because it paid the highest interest rate.

We believe that investing in the highest interest rate maturity sector isn't always ideal. Individuals unintentionally assume reinvestment risk — the risk that interest rate could decline a year hence, when the deposit is due for renewal. Besides, such investments don't map the individual's cash flow requirement. An individual who doesn't require the money for, say, 5 years, unnecessarily locks-in to a one-year rate instead of a five-year rate. Choosing the one-year deposit would be ideal in such case, only if the investor believes that interest rates are likely to move up after one year.

CONCLUSION

Bonds are an important component of individuals' investment portfolio. Choosing bonds, including bank fixed deposits is, however, not about investing in maturity sectors that carry the highest interest rate. Rather, it is to do with mapping investment requirement with the individual's investment horizon, and then choosing an instrument with the best interest rate in that maturity. And when an individual is compelled to choose between bonds of different maturities, using break-even analysis could be ideal.

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