Operation Twist & how does it affect investors?
Have you heard the Reserve Bank of India (RBI) is doing the Twist? I’m not joking. Well, RBI has taken up ‘Operation Twist’. The first lap of this operation was launched on December 19, 2019. This ‘twist’ will help improve long term investments in India. What is this all about?
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Aping the West is a norm and RBI is also joining the crowd. Operation Twist was the name given to a monetary policy operation by the Federal Reserve in the US. Fed is the United States of America’s central bank. Operation Twist in the US first came about in 1961 when the Federal Open Market Committee was looking to strengthen the U.S. dollar and stimulate inflows of cash into the economy. It involved the purchase and sale of bonds. The Fed bought and sold short-term and long-term bonds. This was repeated when there was a global financial crisis in 2008. The ‘twist’ helped the US economy.
‘Operation Twist’ in India is RBI’s version of selling short-term securities and buying long-term securities. This is done using open market operations (OMO). When there is a long-term investment deficit in the country, the government encourages growth by lowering the interest rate for long-term investments. So, RBI sells short-term securities and uses that money to buy long-term securities.Learn how to mange your money & create wealth, Download your FREE eBook now
Why the name?
The name ‘Operation Twist’ was given by the US media due to the visual effect that the action had on the shape of the yield curve. If the yield curve is linear, upward sloping, this action “twists” the yield curve. So, the name Operation Twist. The yield curve twists when short-term yields go up and long-term interest rates drop at the same time.
How does RBI do it?
On December 19, RBI sold short-term securities worth Rs 10,000 crore and bought long-term securities for that amount. It sold government bonds maturing in 2020 and bought those maturing in 2029.
How will the markets react?
This will have an impact on the debt markets and interest rates. So, the returns from debt mutual funds might increase as interest rates fall. How?
There is an inverse relationship between the bond prices and their yields. As RBI buys long-term securities/bonds, its demand will increase. This pushes up the prices of the bonds. However, the bond yield will fall with an increase in prices.
What’s the logic? Investors consider longer-dated bonds as riskier. So, they demand higher yields for holding them. Yield is the return an investor gets on his bond/investment.
For instance, the ten-year bond yield is close to 7.5% while a three-year bond yield is only around 6.5%. RBI will reduce this spread using Operation Twist and will bring down the cost of long-term borrowing without the need for rate cuts. RBI paused the rate cut cycle in its 5 December monetary policy. What about the interest rates? The interest rate in an economy is determined by the yields. When yields fall, interest rates fall. So, all this will help long-term debt mutual funds to appreciate. Lower long-term interest rates have another benefit. What is that? Lower long-term interest rates will help people avail of long-term loans as interest rates fall. This will include loans for buying houses, cars or financing projects. Cheaper retail loans will encourage consumer spending. This is the largest Gross Domestic Product (GDP) component in the economy. Improved consumption spending will help revive economic growth in India.
What was the impact?
Within days of RBI’s Operation Twist, yields on the ten-year government bonds fell from 6.75% to 6.5% in January 2020. What about mutual funds? Long-duration funds have rallied by 1.8% during that time and gilt funds went up by 1.1%.
How does RBI’s Operation Twist affect investors?
Mutual fund investors should understand that long-duration and dynamic bond funds are likely to be the biggest beneficiaries. Many hybrid funds also hold long tenor bonds and their returns might increase. Funds with allocation to bonds with longer tenor will benefit in the near term. If RBI keeps up Operation Twist, it will benefit the ten-year bonds and the categories of funds mentioned above will gain in the short term.
When you choose a fund, you need to measure the impact of interest rate changes on the fund. This will tell you if the fund will gain in the future because of interest rate cuts. How to measure the impact of interest rate changes on a fund? The sensitivity of a fund to interest rate changes is measured by the modified duration of the fund. This will tell you the extent of change in the debt fund’s value as against the change in the interest rates. For instance, a modified duration of four means that a 1% fall in rates will cause a 4% increase in the value of the fund’s portfolio, assuming that all other factors don’t change.
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Why do you need to be cautious?
Even though long term mutual funds are likely to gain in the near term, there are some points you need to keep in mind. Interest rates in the debt market have already fallen by a significant margin in the past year. The benchmark government of India bond yield has fallen from 7.30% to 6.50%, a fall of 0.80%. This has led to a rally in long tenor mutual funds. Gilt funds that invest in long tenor government bonds have given more than 11% over the past year. This is much higher when compared to their five-year average return of 8%. If you look at long-duration funds, they have given returns of more than 12% when their five-year average return is only 8.7%. So, the gains might not be very high in the long term.
The second point is the ongoing slowdown in the economy. This slowdown has hurt the government’s tax collections. Tax collections have had an impact on the government’s fiscal deficit target of 3.3%. What is the fiscal deficit? Fiscal Deficit is the difference between total revenue and total expenditure of the government. A higher fiscal deficit means that the government needs to borrow more money. If the government borrows more, there will be higher interest rates in the economy. As a result, bond prices will go down and so the returns on debt funds will fall too.
Another important point that you need to note is that inflation in India was high in November 2019. It rises to 5.26% from 4.6% in the previous month. RBI has set an inflation target of 4%-6%. If inflation keeps increasing, the central bank might have to be more cautious about cutting the interest rates in India.
These are the implications that you have to note if you are investing in longer tenure mutual funds. If you need help choosing mutual funds, moneysage is here for you!