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Impact of rising interest rates on your investments
Inflation has risen across the globe to become a pain point for policymakers who grapple with rising prices and faltering economic growth. Things seemingly turned worrisome when the Reserve Bank of India (RBI) raised the repo rate by 40 basis points on May 4 and again on June 6.
With the growing interest rates, should investors like you need to worry? What should be your strategy towards investment during such times? Let’s find out.
First, let us revisit the connection between inflation, interest rate, bond yields etc.
Inflation and interest rates are directionally related, i.e. they tend to move along the same trend but with some lag.
RBI and other central banks desire positive but manageable inflation rates. A negative inflation rate or deflation means degrowth in the economy because with rapidly decreasing prices, consumers tend to pause/postpone their spends leading to slowdown in economic activity.
Fundamentally, the supply and demand for money determine inflation. If money supply increases i.e. more money is chasing the same goods, inflation increases, and if money supply decreases so do prices and inflation.
Change in interest rates has the affect on controlling the supply of money in the economy.
When interest rates are increased, the cost of borrowing rises. It makes borrowing expensive. Hence, borrowing decreases, and so does the supply of money.
In a low inflationary situation, the rate of interest reduces. A decrease in the rate of interest will make borrowing cheaper. Hence, borrowing will increase, and the money supply will increase. With a rise in the money supply, people will have more money to spend on goods and services. So, the demand for goods and services will increase, and with supply remaining constant, this leads to a rise in the price level, which is inflation.
Due to the prevailing tensions in the west courtesy the Russia-Ukraine war, commodity prices have steadily increased and inflation continues to skyrocket. In hindsight, inflation is likely to remain over and above the RBI’s current target.
Hence, the RBI has increased interest rates to control inflation, further worrying the bond market. This is why the bond yields rose to 7.4% when the central bank announced the rate hike.
Impact on Stock Market
It is a known fact that equities are sensitive to any change in the interest rates. Moreover, the two functions are inversely correlated to each other. That is, the price of stock increases when the interest rates fall, and vice versa.
However, the below chart shall help you understand that there is a lag effect when stock market reacts to changes to the interest rates. For instance, though the RBI started to hike rates from January 2010, the stock market continued to soar for some time, before the high rates of borrowing starts to hurt earnings.
Further, estimated amount of future cash flows will drop if a company cuts back on its growth or is less profitable, either through high debt expenses or less revenue. This will lower the stock price of the company. If several such companies witness a decline in their stock prices, then the key indices will be affected negatively. With fewer expectations in the cash flow and growth of the company, investors will not get the requisite growth from stock price appreciation. This further can make the stock ownership less desirable.
Impact on Debt
Bond prices and interest rates are inversely proportional i.e. when interest rates go up, prices of existing bonds fall. Further, an increasing interest rate affects every kind of debt instrument. But the impact is more severe on the medium to longer duration debts than the shorter ones. This is because the price fluctuation is very low in short-term instruments.
Hence, debt instruments that invest for a shorter period perform better in a rising interest rate scenario. On the other hand, medium and long term debt instruments witness a price correction.
Impact on Equity Investments
With a rise in the interest rates due to inflation, banks are compelled to hike their lending rates. This increase in lending rate further pushes up the cost of capital for businesses and organizations, further impacting the financials of the companies.
The cost of debt is represented by the 10-year bond yield of the government. If yields rise, it’s thus natural for the cost of capital to increase too. This further lowers the returns to make equities unattractive.
Hence, when a rate hike looks imminent, equity markets have corrected at around 6% in a few trading sessions. Earlier too, we saw how Indian bond yields recorded a historic high of 9% in August 2012, further rocketing up to 22% in a month. This led to a stock market correction of 9%.
Impact on Real Estate Investments
As is seen in the past, whenever the interest rates go up, property stocks tend to lose value at least 60% of the time. Higher interest rates make acquisition costs of new assets more expensive if real estate expansion is financed through borrowings.
Further, rising interest rates can increase the cost of capital of real estate investment trusts (REITs) further resulting in higher cap rates. A high cap rate can also lower the net asset value of REITs, leading to a stock price fall.
Where to Invest in a Rising Interest Rate Scenario?
Accumulate Cash: In the current scenario, bonds are being sold off due to fears that the central bank will start tapering off its bond buying program. This is why the interest rates are rising. When the rates rise very quickly, equities begin to be sold off as well amid the fears of higher opportunity costs and slowing consumption.
During such times, cash becomes even more valuable while the other asset classes decline. It’s always good to have a healthy cash stack to start investing back into equities and bonds once you’ve recognized your risk tolerance.
Invest in short duration funds: You may want to lower the average duration of asset holding with the aim of reducing your portfolio’s sensitivity. When you plan on investing in a rising interest rate environment, you should consider bond funds with coupon rates that float with the market rate.
Invest in real estate, technology, energy and health care: Following a careful analysis, a study has analysed the 13 rising-rate environments that have spanned over the past 64 years. Major sectors like technology and healthcare have recorded average gains to the tune of 20% and 13% respectively during the 12-month period that immediately followed the first rate hike of each cycle. These are favourable reasons when compared to single digit gains in Nifty 50.
Get your borrowings under control: Rising interest rates lead to an increase in the cost of being in debt. Do you have variable-rate debts or debts that will push you to borrow more to pay off at maturity? Now is the right time to figure out ways to pay them off or lock in fixed rates for them. Variable-rate debts will become expensive with every increase in the interest rate. This will further make it expensive to opt for fixed-rate loans.
By paying your debts or financing it while rates are fairly low, you can control more of your income and cash flow. This helps in ensuring that you have enough money available to invest in the first place.
Alternative investment is the way: Amid a rising interest rate scenario, investors can consider investing in alternative assets. Alternative investments are not market-linked and hence reduce volatility to a greater extent. Alternative investments like peer-to-peer lending has been proven to be a good way to brace from stock market correction. Besides, it also offers high yields despite a rising interest rate scenario. Indeed, investing in the stock market over a long term can help beat inflation but P2P lending offers double-digit returns. People who wish to have a diverse investment portfolio should consider the P2P route if they are keen and understand the risks well.
Why P2P Beats Inflation + earn high?
IndiaP2P offers investors an opportunity to diversify their capital by investing at different interest rates. In terms of liquidity, the return of loan starts from the next month itself in the form of equated monthly instalments (EMIs). The EMIs can be further re-invested in traditional asset classes, or within the P2P market so that the capital can multiply by compounding itself. As the interest rates on the platform respond to changes in the base rate, it does consider the inflationary impact to ensure that the real returns to the lender are on the positive side.
Alternative investment options like IndiaP2P are a great way to stay upbeat despite the increasing interest rate scenario.
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