India's premier banking institution – Urjit Patel led RBI, in June 2018 hiked the benchmark interest rate by 25 basis points; a move made after almost four and a half years. This is the rate at which banks borrow money from the central bank and it stands at 6.25%. Multiple factors have been responsible for this decision of the Monetary Policy Committee of the RBI, such as high crude oil prices, weakening Rupee, higher interest rate in the US, rising retail inflation etc. Rising interest rate translates into investors going for more stable and least explosive fixed income instruments. The point is, who gains and who loses and accordingly, what could be the 5 best things to do in such a situation. Let's delve a little deeper into this.
Increase in the interest rates clearly points out that the economy is progressing ahead and is gradually growing in momentum. It fundamentally indicates a stronger accelerating economy with the inflation ticking up. The transmission of a hike in interest rate is quite visible as compared to its reverse. Banks tend to increase their deposit as well as lending rates. This has happened in reality too. It is likely that most banks would follow suit.
Here's the to-do list:
1.Beware of long term investing of any kind, especially in bonds
Longer duration bonds are more susceptible to interest rate movements. Additionally, long term debt mutual fund investment should also be avoided since it will be affected by rising bond yields. It is advisable to exit long term debt mutual funds involving a maturity period spanning 15 to 30 years. It would be a smart move to go for short term debt fund investment as the returns would be better. Also, avoid investment in long tenure bond funds as they depreciate in a rising interest rate setting leading to capital loss. In case of long term debt fund investment, higher interest rate is inversely proportional to the bond price. The fall in bond price will eventually cause the net asset value to drop. In such a situation, it is beneficial to opt for fixed maturity plans, arbitrage funds, liquid funds etc.
2.Portfolio diversification and pooling of investments
A rapidly accelerating economy also means increasing commercial profits. This should be taken advantage of. The financial firms, banks derive benefits from the hike by increasing their deposit and lending rates. One must consider investing in stocks of financial industry in a bid to diversify their portfolio. It would be prudent to invest at different stages of the rate cycle in order to create a pool of investments. This could be done by parking money across multiple sectors/companies instead of relying on a single issuer. A diversified portfolio comes to the rescue in a rising rate environment so that if one sector underperforms, the other well performing sectors will insulate the investor from the blow. The investment basket therefore should possibly contain a wide variety of products ranging from stocks, bonds, low cost mutual funds, ETFs etc. Investors should ideally spend some of their quality time in thorough research and take a decision only after analyzing and evaluating the various types of investment avenues or the type of sector in the economy that would possibly perform well in a rising interest rate environment. This process if done diligently can lead to optimum diversification of investor portfolio.
3.Investment in short term bonds
As part of diversified portfolio, investors should consider investing in short term bonds with a maturity period of less than 5 years. This serves two purposes – portfolio diversification as well as protection from uncertainties in stock market. It would effectively capture the rise in the interest rate.
4.Evaluating FDs without going astray in terms of asset allocation
As banks increase their deposit rates, more and more investors would be tempted to invest in fixed income instruments, possibly disrupting asset allocation. However, investment horizon should also be taken into consideration. Fidgeting with a long term investment in order to gain a near term profit of rising interest rate is not worthwhile. Since they are expected to provide money in the longer term, we cannot expect them to perform now. So it would be wise to keep them intact instead of rerouting them into fixed income avenues.
5.Recurring deposit investment and Investment in NCDs (Non Convertible Debentures)
High interest rate environment is conducive for investment in a recurring deposit account but it is imperative to keep shorter tenure in mind during investment. Fixed income investors with a medium risk appetite could also try investing in NCDs. However, care must be taken not to invest the whole surplus considering the risk factor. A balanced exposure to NCDs is desirable to an extent as they are tax efficient and high on returns too.
Investors must keep an eye out and be prepared to position themselves accordingly, to derive maximum benefit from their investments during the upward trajectory of interest rates. As per investors' perspective when there is a hike in interest rates, the risk-free returns rise as the government bond yields rise. Therefore, in such a situation, it is a given that investors would choose higher fixed rate of returns instead of a highly unstable and lower rate of return from equities. Investors are bound to turn risk-averse as a consequence of rising interest rate. As a result, risk assumes prime significance whereas returns could be secondary. Come what may, investors must tread carefully and make decisions along the line of their risk appetite.