Stock market investors are used to seeing big splotches of red on their portfolios. But for investors in government bonds, this can be an unnerving experience. With central banks across the world aggressively hiking interest rates, media reports have been spotlighting the bloodbath in gilts.
Investors holding long-term UK government bonds are said to have suffered a 50 per cent loss since December 2021 while holders of US treasuries are taking it on the chin too. This bloodbath has been precipitated by the sudden and sharp rise in global interest rates which were ruling at near-zero levels until last year. With the Bank of England and the US Fed taking steep rate hikes, the yield on 10-year UK treasury has soared from 1.8 per cent in August 2022 to 3.4 per cent now, while 10-year US treasury yield has risen from 1.9 per cent in April to 3.9 per cent now.
When market interest rates rise by 200-300 basis points in a matter of a few months, big declines in bond prices are inevitable. It is a basic rule of finance that when interest rates on bonds rise, their prices fall as investors dump older bonds (with low coupons) for new ones. Government bonds are no exception to this rule.
Indian gilt investors are facing the heat from rate hikes too. As the yield on the 10-year g-sec rose from 5.9 per cent in July 2020 to 7.5 per cent in October 2022, the CCIL All Sovereign Bonds Index has lost 10 per cent in price terms. Gilt mutual funds have posted one-year losses of 1-2 per cent.
Given that further rate increases are expected, this puts retail g-sec and gilt fund investors in a dilemma. Should they be cutting losses on gilts and gilt funds before rates can rise even further? Should they trim gilt allocations in their portfolios? Doing either would be an extremely bad idea. The best course of action today is to simply hold on to one’s investments until the gilt matures or when there’s a reversal in the rate cycle.
Ride it out
When a stock you own loses value in a market correction, you can never be sure if the loss is temporary or permanent. Fundamentally sound stocks, if bought at reasonable valuations, can get back to your buy price if markets move up. But if you overpay for a stock or buy into a poor-quality business, your capital losses during a correction can turn permanent.
But losses on government bonds due to rate increases are very different. For one, gilts, unlike stocks, are a capital-protected product. An investor who bet ₹10,000 on 10-year g-secs in a primary auction in December 2020 at a 5.85 per cent coupon would today see her holdings trading below her buy price (because there are new 10-year gilts that offer 7.5 per cent). But if she simply holds on to her g-secs, the government will be sure to pay back her principal value of ₹10,000 in December 2030. The main loss that this gilt investor would face if she held on would be the opportunity loss by earning a 5.85 per cent interest on her holdings for the next 8 years, instead of the 7.5 per cent that is available today.
Two, unlike stocks which guarantee no regular paybacks, gilts offer assured interest payouts. Even if the market price of a g-sec falls after you buy it, you’ll still get the promised coupon on the face value as long as you hold it. These returns can make up for capital losses over time. As gilt yields moved up from 5.9 per cent to 7.5 per cent between July 2020 and October 2022 in India, the CCIL All Sovereign Bonds Index lost about 10 per cent in price terms. But its total returns, including interest, are still at a positive 5.3 per cent. The higher the original coupon on the gilt, the easier it is to bridge the capital losses caused by rate moves.
Three, like stock prices, interest rates go through cycles based on inflation, central bank policies and economic conditions. In India, the last two decades have seen three rate cycles where the 10-year yield has swung between a low of 5-6 per cent and a high of 8-8.5 per cent. Gilts issued in recent years are in the red today because market interest rates have risen quite sharply from the Covid low of 5.5 per cent. But should inflation moderate and RBI pause rate hikes, the losses you see on long-term g-secs will shrink.
All this tells you why the best way to deal with capital losses on your g-secs, is to simply hang on and ride out the rate cycle. This applies to investors in gilt funds too. Since 2005, SBI Constant Maturity Gilt Fund (which holds gilts with an average 10-year maturity) made a loss of 4 per cent in its worst month and 3.3 per cent in its worst year, but for investors who held on till date through three rate cycles, it has delivered a near 8 per cent return.
But gilt investors must be aware of two situations in which they can end up taking a sizeable haircut. One, if you buy long-term g-secs at a premium to face value when rates are low, then you can make a capital loss even if you get back face value on maturity. Two, if you enter long term g-secs or gilt funds when market interest rates are at a record low (unlikely to be repeated in the foreseeable future), then your opportunity loss on interest can be so significant that this badly hurts your long-term returns. Investors in the UK and US who bought long-term government bonds at near-zero coupons are in precisely this situation. As gilt yields in India haven’t fallen below 5.5 per cent even in the recent rate cycle, this is less of a risk to Indian investors. But the global gilt rout is certainly a lesson to investors never to bet big on long-term bonds, when interest rates in the economy are scraping rock-bottom.