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Does a repo rate cut matter to your investments?

In the latest monetary policy review, the Reserve Bank of India cut its benchmark repo rate by 35 basis points of 0.35% to 5.40%. You are right in thinking that your housing loan EMI could look lower if banks follow suit and lower their lending rates too. But what happens to your committed equity and debt fund investments?

In the latest monetary policy review, the Reserve Bank of India cut its benchmark repo rate by 35 basis points of 0.35% to 5.40%. You are right in thinking that your housing loan EMI could look lower if banks follow suit and lower their lending rates too. But what happens to your committed equity and debt fund investments?

Can a repo rate cut impact your market linked investments? Investment returns do get impacted, but not directly. 

A gradual shift

Stock prices and hence, index prices in the short term get impacted by several external factors including change in interest rates. In general, falling interest rates are considered a positive signal as lower rates can boost earnings growth for companies. Which in turn will result in higher stock prices. This happens because, corporates can take loans at lower rates and pass on this as a cost benefit in their profit and loss statement – resulting in higher profit margin. However, it takes time for such shifts to show up in corporate profitability.

What you can expect to see with more certainty is lower returns from your short and ultra-short-term debt funds because lowering of economic benchmark rate normally brings down yields on bonds and money market securities, going forward.

Secondly, lower rates theoretically also induce demand as credit becomes more available at affordable rates. This boost in demand eventually translates to higher consumption by individuals, higher volumes for manufacturers and higher capacity utilisation. If this virtuous cycle follows after a rate cut, then first, sentiment in equity market turns positive and then with a lag, earnings growth also starts to rise for the affected industries.

You may see immediate positive shift in equity prices in reaction to a rate cut but for any change to be lasting, the rate cut has to have a real impact on the business and consumption cycle. This outcome depends on other factors too. Hence, don’t get carried away into increasing your equity investments outside of what you have planned for your goals simply because of a rate cut.

Impact on debt funds is more direct

What you can expect to see with more certainty is lower returns from your short and ultra-short-term debt funds because lowering of economic benchmark rate normally brings down yields on bonds and money market securities, going forward.

Debt has a dual impact. Firstly, with lower rates, any fresh bond issues will come with a lower interest coupon and hence, if these get included in your debt funds, the overall return will be lower than before. However, there is another impact on prices of existing bonds; bond prices move up when interest rates come down, this happens because existing bonds with higher interest coupons become more valuable after a rate cut. This bond price rise will be positive for debt fund portfolios as an immediate aftermath of a rate cut. To that extent debt fund investors should benefit.

However, the extent of gain in a debt fund will depend on the average maturity it holds and the individual securities it holds. What you are likely to see is a slight bump up in your short-term income fund returns as an immediate impact. Over time however, annual yields for such schemes are likely to come down slightly.

In other words, you may see an impact of the rate cut on both your debt and equity investments. But this impact is unlikely to be material enough for you to shift your investment strategy away from your goals.

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