Going by all the signs, the rise in interest rates seems imminent. With global oil prices not willing to mellow down, the impact on India’s already huge oil import bill could lead to inflationary conditions within the country.
In order to keep inflation under control, the Reserve Bank of India (RBI) is expected to hike the repo rate in the near future. Industry experts expect RBI to hike the repo rate by about 0.50 percent during this financial year itself.
The primary indicator that signals a change in the interest rate are bond yields. From a low of 6.675 percent (23 May, 2017) to 7.815 percent (22 May, 2018), it looks like the 10-year government securities (G-Sec) yield will cross the 8 percent mark soon.
Before we get to how rising interest rates can impact investment portfolios, here is how it can have an effect on an investor’s perception about risk and return.
Investors risk appetite in rising interest rate scenario
Rising interest rate brings about a change in the way investors perceive risk and return. “From an investors’ perspective when interest rates rise, the risk-free returns go up as the government bond yields rise. Also, corporate bonds offer better returns when the government yields increase. In such an environment, investors will naturally opt for higher fixed rate of returns rather than an uncertain and potentially lower rate of return from equities. When interest rates rise, investors become risk-averse. Hence, risk is given the first prerogative and returns are considered next,” says Tejas Khoday, Co-Founder and CEO, Fyers, an online brokerage firm.
Therefore, rising rates translates into investors preferring less volatile fixed-income products over more the more unpredictable equity space.
“As interest rates rise, there is a flight of capital into fixed income as an asset class from equities. For example, if interest rates are at 6 percent, the tendency for investors to lock-in money at those yields is low and hence equities tempt them, however, when interest rates are north of 8 percent, investors might be more willing to park funds into fixed income securities like bonds, fixed deposits etc,” says Vivek Banka, founder and CEO, Altiore Capital, a multi-family office firm.
So, in a rising interest rate scenario, how do your investments in equity-oriented and fixed-income products get impacted? If it is effected, how do you correct it? Read on to find out.
I. Equity mutual fund investors
Impact: Rising interest rates in all eventuality can apply the brakes on a rising stock market. Of late, returns from market indices, especially mid- and small-cap indices have dwindled. “Interest rates act like gravity on valuations; higher the interest rates in a country, lower are the equity valuations. It is an inverse correlation,” says Khoday.
Reasons such as rise in oil prices, faltering health of public sector banks, increasing inflation among others may lead to the equity market finding new lows in the near future. “The offset is that corporate earnings have been robust this quarter (top and bottom lines) for a substantial portion of the market. The question is what level will crude become an impediment to earnings, and we think we are already at levels that will result in a dampening of consumer willingness to spend. That has repercussions for equities and continued rise in crude is likely to impact markets negatively,” says Sunil Sharma, Chief Investment Officer, Sanctum Wealth Management.
What to do: These macro economic factors should not deter a long term investor in equities and equity mutual funds. “We would point out though, that the macro conditions can change quickly, so investors need to work within an asset allocation framework and stick to a plan that takes advantages of moves in the market, rather than letting these moves shake them out of a long term investment plan,” says Sharma.
After the recent reclassification of mutual funds, tracking the performance by investors may become easier. “Going forward, investors will benefit by focusing on their fund’s relative performance against its benchmark as well as the peer group during different timeframes,” says Dhawal Dalal, CIO-Fixed Income at Edelweiss AMC.
II. Debt mutual fund investors
Impact: Rising rates is bad news for debt fund investors. When the interest rate starts to move up, the price of existing bonds falls which in turn pushes down the net asset value (NAV) of debt funds, translating into lower returns for the investor. As far as debt mutual funds holders are concerned, the impact of rising interest rates is more on the schemes that hold long-term securities compared to those holding bonds which are maturing early.
What to do: While investing in any of the 16 debt fund categories as classified by Sebi recently, look at the ones with a shorter maturity profile. “Investors should be allocating to ultra-short term funds and corporate credit funds. These funds are likely to deliver the best returns in the current rate environment and can substantially protect investors from a rise in interest rates,” says Sharma.
Debt funds with underlying securities with longer holding period may be avoided. “Avoid long-term bond funds as they depreciate in a rising interest rate scenario resulting in a potential capital loss,” says Khoday.
According to Dalal, this is what debt fund investors with moderate risk appetite and those who are risk-averse should do:
* Risk-averse investors should consider investing in liquid funds, arbitrage funds, ultra-short term funds and fixed maturity plans at this point based on the current market conditions.
* Investors who can withstand some amount of risk and with a medium-term investment horizon should consider investing in high quality fixed-income funds with duration range between 1 year and 3 years via systematic investment plans (SIPs). They should spread their investments over 3 to 4 instalments for six months or so. This may help the investor take advantage of the upward trend in bond yields and help mitigate downside risks.
III. Fixed-income products
Bank fixed deposits
Impact: Rise in rates can be good news for investors who rely on fixed income products such as fixed deposits (FDs). Currently, the interest rates offered by bank FDs are largely in the range of 6.5 percent to 7.5 percent (1 year to 10 year tenures) and can see a rise depending on RBI’s repo rate, the bank’s liquidity, and demand for credit in the economy.
What to do: Banks may hike their deposit rates soon. Ultra conservative investors who opt for bank FDs may either wait before locking up their funds or choose shorter tenures.
Impact: Wanting to take advantage of the upward trajectory of interest rates, companies such as Dewan Housing Finance Corporation (DHFL) and JM Financial Credit Solutions (opens May 28) have launched non-convertible debentures (NCD) issues. While the former is offering 9.15 percent, the latter is offering 9.75 percent.
What to do: There could be several more NCD offerings in the near future. The interest rate offered is competitive when compared to bank FDs. Fixed income investors with moderate risk profile may take some exposure in NCDs keeping the various risk factors in mind. “At their current yields, these bonds are pricing in at least two rate hikes in the medium-term. To that extent, investors have a built-in safety at current levels,” informs Dalal.
Small savings products
Impact: The interest rate of the Public Provident Fund (PPF) is set by the government every quarter based on the yield (return) of government securities. As of current quarter, i.e., April-June 2018 quarter, the rates have remained unchanged over the previous quarter. With the bond yields rising over the past few quarters, the expectation is high that the interest rate on small savings schemes will also witness an increase.
What to do: Investors looking to invest in small savings may stand to benefit if they can wait till rates for June-August quarter are announced.