How to Profit from interest cycles

If you thought equities are the only option to generate capital gains from inve s t m e n t s, think again. While there is no denying the merits of buying equities, profits in abundance can be generated in other forms of products. For a moment, put your equity bias aside and look around.

The world of bonds and fixed income securities offer no less an opportunity to generate capital gains. Interest rates keep changing in long cycles and when the rate cycles trend downwards, they create tremendous opportunities for capital gains.

Predicting the interest rate cycles correctly and making intelligent investments in fixed income securities and bonds will leave you richer than you imagined. Investment legends like Bill Gross and Warren Buffett generated prolific profits playing the debt cycles. The important thing is that you can do just as well if you set your sight right.

How does this work?

When interest rates fall, bonds and fixed income securities issued at higher rates tend to appreciate as investors are willing to pay more for higher return-generating papers. The term of the papers also tends to impact the extent of appreciation. Currently, interest rates have peaked out and one rate reduction of 50 basis points has happened. RBI is expected to reduce rates going forward and any drop in inflation will hasten the process of reduction.

As inflation drops sequentially, interest rate reductions will inevitably follow. This process happens over a 24-30 month horizon. The drop in interest rates tends to raise the prices of bonds and fixed income securities. Buying the right fixed income securities with a term that matches your expectations on interest rates will ensure you profit significantly as rates progressively drop. When the interest rates get closer to a bottom, you would have made bumper profits in your debt portfolio if you built it right.

What should you do?

If you know how to price bonds and fixed income, you can buy the right papers directly. An effective alternative is to buy the right schemes of mutual funds that invest in gilts, bonds or a mix of both. If your return expectations are higher, you must choose gilt funds that have a portfolio of papers with the right term. Typically, a 24-30 month term should ensure that rates drop adequately to generate above-average returns. Buying portfolios with a very long term may not generate very high returns as the cycles could reverse within the term of the paper and this could cap profits. In fact, papers with very long tenures may not give as much returns as those with medium tenures. So choose the right fund with the right tenure and let the competent fund manager do your bidding.

What should you prepare for?

Conviction is a prerequisite and constant self-doubt will hardly help. Be prepared for little or no returns in the initial quarters and for bumper returns when interest rates fall sharply. The progressive cuts in interest rates by RBI will catalyze returns and you must show adequate patience. Close monitoring of inflation data, the liquidity position and the government's borrowing plans are essential as they tend to influence interest rates. Importantly, you need to understand that returns inevitably get lumped up in the later quarters and adequately compensate for the earlier quarters.

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