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How To Invest In A Rising Interest Rate Environment

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The Yields on Commercial Papers (CPs) and Certificates of Deposits (CDs) are nearing the 10-year G-Sec levels (long term risk free rate). This has implications for investors in debt instruments, who are looking how to invest in such a rising interest rate environment.

Inverted Yield Curve Often Heralds Recession

The governments around the world, in their urgency to enable their health care systems and avoid a systematic failure, in the Covid-19 pandemic, introduced heavy liquidity. This excess liquidity has caused countries to catch a new infection: inflation!

Not combat this, interest rates are being hiked. We all know that when yields on short term paper exceed yields on longer dated securities, such a phenomenon is called an “inverted yield curve”. As per Economic Theory, an inverted yield curve is a lead indicator of economic recession. Almost every major global economic crisis has been preceded by an inverted yield curve. Thus, rising short-term interest rates is not good news for the economy.

However, it also indicates that the markets do not expect interest rates to remain high for a longer period of time. This is also because Central Banks respond to recessionary fears with a cut in interest rates. To be able to do this, the Central Bank should be convinced that inflationary pressures have receded.

How To Invest In A Rising Interest Rate In The Indian Markets

As things stand today, India appears to be dodging the recession. It is set to be the fastest growing economy. While we are seeing an increase in short term rates, and the RBI may further hike Repo rates in the months to come, the yields on longer dated securities are not keeping pace. This means, the markets are expecting interest rates to peak and start the downward journey to support growth, over the next 6 to 12 months.

Coming specifically to whether investors should shift funds from longer dated paper to short term paper, we believe the 2 instruments (Short term debt and long term debt) serve 2 different goals.

  • Short term paper is ideal to meet liquidity requirements
  • Longer term paper is to provide stability to the portfolio.

It is advisable not to mix the two; also not to worry too much about how to invest in in rising interest rates. Let the goals be managed based on the long term allocation plans. More eon this in the concluding para.

How Will Yields Move?

Given the global squeeze in liquidity, it will not be a surprise to see yields on Short term interest rates over shooting yields on G-Secs. We are already seeing this in the US markets. The US has already had 2 quarters of negative GDP growth, but we have stopped short of saying that it is in recession. Here is how the rate hikes have happened so far in 2022:

Clearly this is one of the steepest rate hikes in recent times. Given that the inflation has not reduced even post the rate hikes, there may be more rate hikes to come in the near future. The Fed has indicated that it will tackle this inflation through continued rate hikes.

How does interest rate affect your investment? Depends on whether you are an investor vs trader. Long term investors are unperturbed by short term market swings, inflations or recessions. Traders are impacted due to the volatility these kind of markets bring.

If headline inflation remains above threshold, RBI will go for another hike in interest rates, which can see Short term yields going above long term yields in India also. However, this may be for a short period. We expect India to attract FDI as well as garner increased FII allocations for 2023. Increase in Cash inflows should ease liquidity position and soften interest rates.

Will we see more CPs/CDs issued?

Just like investors need to plan investments keeping in mind their financial goals, consumers of capital need to plan issues based on their business plans and appropriate capital structure. If an organisation is going ahead with its projects which require long term capital commitment, then it makes sense to go for longer term debt rather than raise short term money at higher rates. However, if there is a capital crunch, then organisations can try to tide over the problem of delay in projects by raising money at higher rates for the short term, hoping to substitute it with long term funds as liquidity improves. We might see some spike in the issue of Commercial Paper in the coming months.

What will be the impact on Equity Investments?

Generally when rates are increased by central banks, the cost of capital goes up. Most companies feel the cost of capital on their balance sheets and their bottom lines come under pressure.  If there is already a high inflation environment which the rate hikes are trying to tackle, then commodities, product and services are all getting dearer. This means, the demand would eventually slow down which would bring top line for most companies under pressure. 

So, what happens to stocks when interest rates rise? Overall the above issues bring revenues and profits under pressure. Stocks with a low debt to equity ratio generally do well in these conditions due to lower obligations towards payment of interest. These dual issue are why are equities are volatile during this time. But amongst the broader index, there are a few stocks to buy when interest rates rise:

  1. Financial stocks: Banks, insurance companies and brokerages do well in high interest rate environments. 
  2. Healthcare: Healthcare inflation generally outstrips the CPI index and investing in stocks that have pricing power to pass on this inflation to the customers is a good bet. 
  3. Consumer staples: The consumption story especially in the food and beverages, consumables, alcohol and tobacco area has been compelling as we came out of the pandemic. 

Impact on Bonds

Generally, long term bonds do not benefit from the volatility and rising interest rates. But there are certain debt instruments that do benefit in this environment. These are incidentally the top secure investing options in this environment. How to build a debt portfolio?The textbook recommendation for a debt heavy portfolio in retail is still 60% (equities) : 40% (debt/bonds).

  1. Short-term bonds: Short-duration debt mutual funds are poised to make use of the higher interest rates during times of inflation. This is something Long-term debt mutual funds cannot use to their benefit. 
  2. Ultra-short duration debt funds or Money market debt funds which have tenures from 6 months to a year, again falls under the same category. They have an advantage in high inflationary periods owing to the higher interest rates. 
  3. Inflation Adjusted Treasury Bonds which are issued by the RBI especially to mitigate the effects of rising inflation are a good option. There are also floating rate bonds whose coupon moves in tandem with the market interest rates. 

Precious Metals

Gold and Real Estate have been traditional stores of value. These tangible assets tend to rise in a high interest rate environment. Gold being a commodity appreciates with inflation. It is called a hedge against inflation for this very reason. Though over the last few years, the correlation of gold with inflation has decreased significantly. Gold prices have not surged in this inflation cycle and therefore investments in gold have opportunity cost. One is not recommended to have more than 5% of portfolio allocation to gold. 

Sovereign Gold Bonds issued by the Government of India, are a better way to invest in gold since it pays 2.5% interest and does not require the investor to worry about storing the physical gold assets. 

Real Estate

Real Estate has a mixed reaction in an inflationary environment. The cost of capital increases with rising interest rates, which means, loans and mortgages become dearer. Despite this increase in cost of home ownership, real estate tends to rise in such environments.  Due to inflation, the rental yield also goes up for existing property holders. 

REIT or Real Estate Investment Trust is a great way to invest in commercial real estate without the high ticket sizes or buying entire offices. REITs also offer liquidity alongside these benefits.

Conclusion

Investments should be as per financial goals for which they were made. It may not be a good idea to incur transaction costs to earn a few extra basis points of interest. One also needs to factor in taxation. If investors are holding GILT Funds, redeeming them to profit from spike in Short term interest rates may attract tax that could be minimised if Gilt Funds are held for a period of more than 3 years. Investors must consult their Registered Investment Advisors, before embarking on such a shift in asset allocation.