Do not invest in debt because interest rates  are going up.

You may have heard this advice and, it may have puzzled you. Why would debt be a bad investment if interest rates are going up?

Here is an explanation of this paradox.

For example, you have invested Rs1,000 in a one-year fixed deposit account, at an interest rate of 6.5 per cent. The interest rate on new fixed deposits is hiked to seven per cent. A year later, you receive Rsfive less than someone, who invested at the higher rate. Conversely, if the rate was cut to six per cent, you receive five more. This example indicates how the value of debt can decline if interest rates go up.  Contrariwise, it goes up if interest rates fall.

There are important implications. Assume the interest rate has risen. You decide to redeem the fixed deposit. The bank will charge a fee for early redemption. So, you try to sell it to someone else.

Now, that entity says, “Look, I could invest in fresh fixed deposits and receive `five more in interest. So, I will buy it at a discount.” If the interest rate had gone down instead, you could have sold the same for a premium, by applying the reverse logic.

The same logic applies if you refinance a mortgage. The refinancer redeems the existing mortgage and issues a fresh mortgage, taking interest rate changes into account. The terms of this bargain depend on the interest rate trend.

Corporates, debt mutual funds and governments issue debt, and buy and sell those on a daily basis in the bond markets. Interest rates vary by tenures, and for different risk assessments. But the underlying principle is always the same - the value of debt falls if interest rates rise and vice-versa.

Government debts (such as Treasury Bills or T-Bill) are risk-free since government do not usually default, while various types of corporate debt carry varying risks of default. Forex traders also have to look at overseas interest rates when they try to guess exchange rate fluctuations.

Every debt trader makes informed guesses about the future trends of rates. Some of which will change daily, depending on short-term liquidity in the banking system, funds at the disposal of lenders, and mutual funds.  A trader can make substantial gains or losses, while trading in debts if they make the right or wrong calls.

For instance, a Government 364-day T-Bill (they are auctioned in the markets) pays Rs100 at maturity, a year later. The yield at maturity, as it is called, depends on what the buyers pay at auction. The T-bill was sold at Rs93.22 at the last auction. So, the yield was 7.27 per cent. 

Now, a trader may discover rates are falling. So he buys the T-Bill at Rs93.25 and sells the same at Rs93.35. That is a tiny profit of 0.101 per cent. But one such successful trade per day earns 27 per cent return in a year with 250 working days. Debt funds making this sort of trade can therefore make big gains, or losses.

Interest rates have been going up for the last year or more, for various reasons, ranging from a strong dollar (yes that affects India), to the cash crunch caused by slow GST credit, and the ongoing bad loans and defaults crisis affecting banks and non banking finance companies. The government is also borrowing a lot of money because of its high expenditure in the next-year elections.

That is not a good scenario for debt funds. Nor is it a great scenario for fixed deposits. If you are heavily invested in debt, this is a good time to consider cutting the exposure. Look at equity instead. Or consider gold. At the very least, try shifting to short-term fixed deposits, or to “liquid” mutual funds, which deal in short-term debt. That way, if interest rates do rise, you will be able to quickly exit and thus, minimise the damage.

The author tracks economic, behavioural and corporate tends, hoping to gauge good avenues of return