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India’s 1-year G-Sec is trading at 6.75% and 10-year G-sec yields 6.85%. The difference is only 0.10%.
5-year G-sec is trading at 6.76%—almost at the same level as 1-year G-sec. This indicates that the yield curve is flat.
There is a peculiar situation here. Usually, as the duration of any debt security increases (from the same issuer, in this case, it is GOI), the yield also goes up. Because an investor would want a premium for an investment that will mature later in the future. The farther the future is, the more uncertain things become and hence carry an uncertainty premium.
Therefore, the normal yield curve is usually sloping upwards in a growing economy. An inverted yield curve indicates a slowdown or recession.
Sometimes, the yield curve also gets distorted by the flow of excess money towards a particular duration of securities. Since the inclusion of Indian G-sec in many global debt market indices, many passive funds have been allocating to long-dated Indian G-sec securities which is causing the prices of these securities to go up. The yield and price of debt securities have an inverse relationship. If the prices go up, yields go down, and vice versa.
In a declining interest rates scenario, investors tend to invest more in long-duration funds to lock in the yields at higher levels before the interest rates go down. The longer the duration, the higher the capital gains when the interest rates decline as other investors would want to pay higher for securities are that giving higher interest rates till the time it matches with current market interest rates.
It is widely expected that key policy rates set by the central banks will go down over the next 1 year globally as well as in India. Unfortunately, at the current juncture, an investor may not benefit much by investing in long-duration debt security since there is hardly any premium over short-duration securities. Most of the expected decline in the interest rates has been fully captured by the market, especially due to distortion created by excess flow.
In case, the decline in key policy rates is only 0.50% to 1%, as expected, there may not be much to gain by investing in long-duration securities. On the contrary, if the policy rates are reduced by lower quantum than expected or any flare-up in Global commodity prices, investing in long-duration funds will result in negative returns in the short term. Hence, the risk-reward is not very favorable for long-duration funds.
I would therefore recommend ignoring sales pitches that are telling you to invest in a long-duration (> 5 years) debt portfolio. At the current juncture, one should allocate their debt investments to short/medium term (1-3 Years duration) debt portfolios.
Originally posted on LinkedIn: www.linkedin.com/sumitduseja
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