Yield Curve has FLATTENED OUT

Yield curve can be prepared by plotting interest rates for various maturities on a graph paper. These maturities ranges from 3 months to 30 years. Logically Interest rate for 3 months will be lowest & for 30 years will be highest. Yield in layman terms means interest rates. Also yield curve can be termed as interest rate curve. Slope of yield curve says a lot about state of the economy and future of economic activity.

At various point of time we can see different slopes for yield curve.

1.  Normal Yield Curve – When the yield is increasing incrementally for higher tenure. This will denote normal expansion in economic activity.

2.  Steep Yield Curve – This can be seen when there is highest difference between 3 months interest rate and 30 year interest rate. Normally in excess of 3%. This denotes that the economic expansion will be fastest in times to comes. Also this signifies that demand for long term money is highest which goes towards creating capacities, which is long term in nature.

3.  Inverted yield curve – This is typically when interest rates are high and economic activities are slowing down. Demand for long term money is lower since people fear slowdown. Short term rates goes up due to increase in inventories and working capital. Also smart investor try to lock their money at higher interest rate before fall in economic activity.

4.  Flat Yield Curve – This is where the rate across maturities is flat. Yield curve can move in any direction – towards normal yield curve or inverted yield curve. This is where one has to be cautious. This is early signs of slowdown in economic activities. Nine out of ten times it will lead to inverted yield curve.

Today as we speak we have pretty flat curve where 3 months and 30 years money is available at same interest rate. Today market is advising short term funds where they are expecting yield curve to become normal by reduction in short term rates and increase in long term rates. We at JAIN INVESTMENT believes that economic activities will slow down and long term rates may remain same or go down and short term rates may move up making yield curve inverted. We are advising our client to be either in liquid or at longer maturities (If you are investing for long term).

Caution – Last time yield curve became inverted was October – 2008. I hope you remember what followed. 

Time to look at Gilt Fund

Gilt fund are fund which invest in Government of India Securities. These are safest instruments in India with sovereign rating. There is no default risk in Gilt.

Risk profile – Moderate Risk

These instrument are subject to interest rate risk. They work inversely to movement in interest rate. If we buy 10 year GSEC paper @ 8.82% today and interest rate moves up Gilt prices will come down and vice versa. As government finances are in bad shape due to rise in fuel subsidy they will have to aggressively borrow in next six month. Market is factoring in aggressive borrowing and hence yield has gone up from 8.30% to 8.82%. This may further go up to 9.0%.

If we buy @9.0% 10 year Gsec paper and if interest rate come down by 1.0% in next 1 year we will have paper which is earning 1% more for next 9 years, which will be converted into premium for these paper by 6% to adjust to fall in interest rate. So return will be carry of 9.0% and capital gain of 6% which makes it 15%. In case of interest rate going up by 1% we will have 9%-6% = 3%.

In our opinion we are nearing the peak and any further rate hike will be detrimental to growth. Also there are imminent signs of slowdown. We would advise you to enter these funds in systematic manner.

Our advice is to look at combination of liquid plus / short term / Gsec funds in these high interest rate environment.

After peaking out of rates there are two possibilities.

1.       Fall in interest rate like 2008 where commodity prices come off sharply and interest rate come off sharply. In this period Gilt fund delivered 28-40% return in one year. This is less likely scenario.

2.       Fall in interest rate over next 2-3 years where interest rate cam off slowly and return in gilt fund was in excess of 15% for next three years.

This is time to avoid Fixed deposits as banks will go ahead and invest these money in such instrument to make capital gain.