Interest rates in India have been on a downward cycle for the past three years. The yield on the benchmark 10-year government bond tumbled from 9% in 2014 to 6.5% in August 2017. However, the trend has gone into reverse since September 2017 with the benchmark yield crossing 7%.
This is based on the expectation that the RBI may reverse course and increase interest rates due to rising inflation. Central banks around the world are also raising interest rates. So what does this mean for your investments?
Debt mutual funds
In general, rising interest rates will play spoilsport with your debt funds. Debt funds make money by holding bonds which pay out interest. When rates rise, the existing rates on these bonds look relatively less attractive, causing them to lose value. Gilt funds and income funds which hold long-dated bonds are more vulnerable to interest rate movements. You can reduce the damage to your portfolio by sticking to short-term, ultra short-term and liquid funds. A useful measure of just how vulnerable a fund is to interest rates is its ‘modified duration’. This number measures how sensitive the fund’s portfolio is to interest rate movements. The higher it is, the more value the fund will lose.
Equity mutual funds
The effect of rising interest rates on equities is mixed. If rising interest rates reflect a robust economy, the earnings of companies will also rise. On the other hand, the value of those earnings is discounted by a higher rate and this will lower stock valuations. The net effect depends on which of these two forces is stronger.
Funds which hold both debt and equity (such as Balanced Funds and Monthly Income Plans) will be more impacted than pure equity funds and less impacted than pure debt funds. The effect on these funds depends on two factors – their debt-equity mix, and the type of bonds they are holding. Funds which hold longer-dated bonds face a higher risk from interest rate hikes.
FDs face an impact from rising interest rates that are similar to debt mutual funds. Since you have already locked in your money at a lower rate, you lose out on the higher current rate and this technically ‘lowers’ the value of the FD. However, you can ‘break’ the FD by paying a premature termination penalty (usually 1%) and form a new FD at the higher rate.
EPF, PPF and Small Savings Schemes
The interest rate on PPF and several other government savings schemes is reset every quarter and is linked to the overall interest rates in the economy. The EPF interest rate is also announced by the EPFO every year and it tends to move in the same direction as overall interest rates in the economy.
Hence, the impact of these schemes is likely to be neutral. However, for schemes such as Pradhan Mantri Vaya Vandana Yojana (PMVVY) where the interest rate is set for the duration of the scheme, the impact is negative just like it is with fixed deposits.
Real Estate and Gold
Rising interest rates adversely affect the demand for real estate since buyers have to shell out more for bank loans. If you receive income in the form of rent which is fixed, this will also be discounted at a higher rate and hence lose value.
Gold does not generate any interest and also loses value because the opportunity cost of holding it increases.
In summary, rising interest rates are a tough environment for most investments in your portfolio. The best strategy in such a scenario is to stick to conservative, short-term instruments like liquid funds. However, if you have ongoing SIPs, don’t stop them. Interest cycles are difficult to time and will not affect your equity returns over the long-term.