When you hear the term ‘interest rate’ are you automatically thinking about your home loan rate or your personal loan rate?
You’re not wrong in doing that but it’s also worth keeping in mind that the reference ‘interest rates’ has a much wider impact when it comes to your money life.
The other thing is that interest rates keep changing. The trend is sometimes for rates to reduce and at other times for rates to move upwards. The reference to interest rates is really the central rate which is used as a benchmark for an economy.
In India, it is set by the Reserve Bank of India (RBI); all other lending and borrowing activity in the economy happens at interest rates which are a trickle-down from this central rate known as the repo rate.
Interest rates and portfolio returns
The repo rate was been trending lower for the last 10 years since the end of 2011 when it had reached a peak of 8.5%. Currently, the repo rate in India is at 4%.
This has been a long downward trending phase for Indian interest rates, however, it’s worth mentioning that for the last nearly two years, this benchmark rate has remained stable.
This along with other domestic and global macro factors indicate that it could be time for the trend to turn upwards.
When interest rates start to increase, three things happen to your portfolio.
Firstly, on the fixed income side of your portfolio, expected returns from bank and corporate fixed deposits and bonds will go up. However, this pertains to new issues and fresh deposits, the ones you currently hold won’t be adjustable to a new rate.
Secondly, the effect on your market-linked debt portfolio will be dual; when interest rates increase, the immediate impact is for bond prices to fall hence, you may see some drawdown in debt mutual fund NAVs. At the same time, if you are holding on for the medium term, say 2-3 years, the portfolios will add fresh bonds and new issuances, taking up the portfolio yield in line with the rise in rates.
In other words, beware of short term volatility or trading losses in bonds and managed funds when interest rates rise, but over time you are looking at higher yield from debt investments.
Lastly, change in interest rates also impacts the equity side of your portfolio. Rising rates mean rising interest costs on corporate debt and hence, a fall in corporate profitability. On a standalone basis that is not good for stock prices and stock markets.
However, one has to assess this negative impact in context to the larger picture of revenue and earnings growth being managed by individual corporates.
The initial stock market impact from rising rates could be negative. The volatility can last longer depending on the indications around how long the rate increases will last. The severity of any such volatility will also depend on the size of the actual rate cuts as and when they happen versus the market expectation.
How to deal with this volatility?
In other words, if interest rates are to go up, then you have to be prepared to face volatility in your portfolio returns both on the market-linked equity and debt side.
While fixed return deposits and bonds will not display this volatility, they will not add incremental benefit as rising interest rates often come with high inflation too which eats into the real return from such fixed income options.
When interest rate cycles turn, your best option is to hold on tightly to your long term portfolio and absorb the immediate volatility. Any near term requirements can be shifted to fixed return financial products. More than anything, being aware of the impact can help you ride through the period of uncertainty with minimum jolts.