The yields on commercial papers (CPs) and certificates of deposit (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 at 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 healthcare systems and avoid systematic failure, during the COVID-19 pandemic, governments around the world introduced heavy liquidity. This excess liquidity has caused countries to catch a new infection: inflation!
To combat this, interest rates are being hiked. We all know that when yields on short-term paper exceed yields on longer-dated securities, this 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 are 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 with rising interest rates. Let the goals be managed based on the long term allocation plans. More on this in the concluding paragraph.
How do Will Yields move?
Given the global squeeze in liquidity, it will not be a surprise to see yields on Short term interest rates overshooting 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 inflation has not reduced even after 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 the interest rate affect your investment? It depends on whether you are an investor or a trader. Long-term investors are unperturbed by short-term market swings, inflations, and recessions. Traders are impacted due to the volatility these markets bring.
If headline inflation remains above the threshold, the 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. An increase in cash inflows should ease the 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 organization is going ahead with projects that require long-term capital commitments, 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 organizations can try to tide over the problem of delays 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, products, and services are all getting dearer. This means the demand would eventually slow down, which would put the top line of most companies under pressure.
So, what happens to stocks when interest rates rise? Overall, the above issues put revenues and profits under pressure. Stocks with a low debt-to-equity ratio generally do well in these conditions due to lower obligations towards interest payments. These dual issues are why equities are volatile during this time. But among the broader index, there are a few stocks to buy when interest rates rise:
- Financial stocks: Banks, insurance companies and brokerages do well in high-interest-rate environments.
- Healthcare: Healthcare inflation generally outstrips the CPI index and investing in stocks that have the pricing power to pass on this inflation to the customers is a good bet.
- 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 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 do I build a debt portfolio? The textbook recommendation for a debt-heavy portfolio in retail is still 60% equity and 40% (debt/bonds).
- 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.
- Ultra-short-duration debt funds or Money market debt funds which have tenures from 6 months to a year, again fall under the same category. They have an advantage in high inflationary periods owing to the higher interest rates.
- 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.
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 inflation. It is called a hedge against inflation. 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 an 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 they pay 2.5% interest and do not require the investor to worry about storing the physical gold assets.
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 more expensive. Despite this increase in the 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.
Investments should be as per the 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 the 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.