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Investing In Times Of Rising Interest Rates

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Interest rates are usually decided by the central bank of a country. In India, that is the Reserve Bank of India (RBI).

They have two main goals:

To keep prices stable i.e., to monitor and manage inflation so it doesn't get out of control.

To encourage employment and help grow the economy during an economic slowdown.

So, how does the central bank do that?

Changing interest rates is one of the most powerful tools the RBI has. They use it to increase or decrease the spending in the country or to 'steer economic activity' during a downturn.

Let’s Look At 2 Different Scenarios: Scenario1: RBI Wants To Create Employment In An Economic Slowdown
 

Let’s Look At 2 Different Scenarios: Scenario1: RBI Wants To Create Employment In An Economic Slowdown

They start out by lowering interest rates.

Finding it attractive Individual A decides to take loan and buy a house. When you buy a house, you generate employment. The house needs a paint job, furniture, light fixtures etc. Simultaneously, the person selling the house and moving will also need similar services. Unknowingly, a single purchase/sale of a house has had so many ripple effects and helped create employment.

Scenario2: Inflation Is High And The Prices Of General Products Are Rising

Scenario2: Inflation Is High And The Prices Of General Products Are Rising

So now the RBI will try to slow down the economy and steady those prices. They increase the interest rates. Now the same individual will refrain from buying a house as it will be more expensive to take out a loan. Generally, people will borrow less amount of money and thereby buy fewer things. This will lead to lower demand for goods and the prices will fall and help keep inflation in check.

Rising Interest Rates. How Does It Affect My Investment Portfolio? Debt And Debt Mutual Funds
 

Rising Interest Rates. How Does It Affect My Investment Portfolio? Debt And Debt Mutual Funds

Bond prices and interest rates are inversely related. Rising rates is bad for the debt instruments and fund investors. As interest rates move up, the price of existing bonds falls resulting in a falling net asset value (NAV). This translates into lower returns for the investor.

The impact of rising interest rates is more on bonds with longer maturities or schemes that hold them compared to those holding bonds with shorter maturities.

What Should The Investor Do?

To hedge themselves against the interest rate risk an investor should look for bonds that mature faster. Short term Bonds from credible issuers (Government, AAA corporates etc) are the way to go. So if interest rates rise it's likely that your Bond will be up for renewal or already reflects the higher interest rate after renewal.

Stocks And Equity Mutual Funds: Equities

Stocks And Equity Mutual Funds: Equities

As interest rates rise so does the cost of money. The general public finds ways to reduce spending. Not eat out often, purchase only what's necessary etc. basically cut down on any extra expenditure.

This affects the product manufacturers, the service providers. Which are effectively the companies that are listed on the stock exchange. Their earnings will fall or their cost of borrowing might rise resulting in a stock price fall and by extension the stock market.

But only over the short term.

Financial institutions such as banks, brokerages and insurance companies etc are positively affected by an increase in interest rates. Mainly because they can charge more from their lenders.

What Should The Investor Do?

Long term investors in equity need not worry about changing interest rates. It's a part of every economy and affects a fundamentally strong company temporarily.

Make sure you invest in a company with a fundamentally strong balance sheet.

There are many companies that went belly up in a high interest rate environment mainly because of the truck load of debt: The Essar group, DLF, GMR Infra etc.

Read the annual report. Derive a few ratios.

Total Debt-Equity: (Total Debt/Total Networth Equity) the lower the better

Total Debt to assets: (Total Liabilities/Total Assets) the lower the better.

Interest Coverage Ratio: (Earnings Before interest and Taxes/Interest Expense): the higher the better

Make relevant comparisons with existing peers to gain a better understanding.

Bank fixed deposits

Bank fixed deposits

Rising interest rates can be good for Fixed Deposit investors. If the RBI increases interest rates the banks may also hike that FD rates depending on their liquidity, credit status etc.

What Should The Investor Do?

If you expect an interest rate hike soon its best to wait before investing or choose short tenured FDs so you can renew faster.

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