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A Strategy For Rising Interest Rates By Deepti S Patel, CFPCM, Director, Finacrest Wealth Pvt. Ltd.

It is well-known that the portfolio equivalent of not putting all your eggs in one basket is to diversify your portfolio investments across multiple asset classes and strategies. Two asset classes that commonly find their way into investor portfolios are equity and debt.

Deepti Patel
Deepti Patel

It is well-known that the portfolio equivalent of not putting all your eggs in one basket is to diversify your portfolio investments across multiple asset classes and strategies. Two asset classes that commonly find their way into investor portfolios are equity and debt. While you invest in equity to potentially benefit from the long-term growth potential of this asset class, you choose to invest in debt as it traditionally offers relatively stable returns and protects portfolio downside. Further, many people increase their exposure to debt securities in the false belief that these investments carry little to no risk.  

The interest rate risk in fixed income 

However, it is important to understand that fixed-income or debt securities do carry risk which needs to be mitigated. The main risk in such investments is the interest rate risk. The price of a bond is inversely proportional to the interest rates in the economy. If interest rates go up, then the price of the bond falls and if interest rates go down, then the price of the bond rises. Take for example a 2-year bond which pays an interest rate of 10% per annum and is currently available at Rs. 100. You buy this bond at Rs. 100, today. One year later, the interest rate in the economy rises to 11%. What happens to your bond now? 

The bond that you are holding now has 1 year remaining till maturity and pays 10% interest. However, due to a rise in interest rates, a new 1-year bond is now available at an interest rate of 11%. This makes the bond that you hold less valuable. Now, if you want to sell this bond in the market, you will have to sell it at a lower price in order to compensate for the interest rate differential. The bottom line is that as a result of an increase in interest rates, the price of your bond fell.  

Investing in a rising interest rate environment 

An understanding of this becomes important in the backdrop of the current landscape. After a fairly extended period of near zero or fairly low interest rates, central banks across the world have started raising rates in a bid to contain rising inflation. In a matter of 45 days, the Reserve Bank of India (RBI) has raised interest rates by 90 bps, taking the prevailing repo rate to 4.90%. Inevitably, the value of your fixed income portfolio would have fallen in response to the rate hike. However, it also opens up interesting investment opportunities for the future.  

In a rising interest rate environment, there are likely to be good investment opportunities to lock in long-term money in government securities and State Development Loans (SDLs). These are very low risk instruments that usually offer interest that are commensurate with their risk rating, i.e., low interest rates. However, in a rising rate regime, you get the opportunity to invest in these more or less risk free securities at higher interest rates. Currently, the 4-5-year yield curve is looking lucrative and gives a good investment opportunity as compared to the much longer yields. It is also important to highlight that the gap between the 1 year and the 4-5 year yields has widened significantly. Currently, the 2027 / 2028 maturity G-secs are yielding close to 7.38% as most of the repo rate hike has already been built into the prices in this area. 

Further, with a hold-till-maturity (HTM) strategy, you can start locking in funds in a staggered manner from now and over the next 3-5 months. Further, as you deploy your money, you need to ensure that the money that is to be invested at a later date is not kept idle. Hence, you should consider investing this money in a floating rate scheme or in roll down maturity schemes where you can expect to generate upward of 6% returns pre-tax and expenses. Additionally, if you wish to go up the yield curve, then you can consider investing in AAA rated govt bonds that have now started to yield anywhere up to 7.6%. 

 Risks are as much a part of investing as returns. Generally, when we see these risks, like the risk of rising interest rates, we tend to become cautious and exit our investments in a hurry. However, such times can also engender great opportunities to enhance the risk-adjusted returns of your portfolio. A good investment strategy would be to deploy funds in debt instruments for the long term, capitalising on the current upward interest rate cycle.

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