The relative calm with which the 25-basis-point rate hike by the Reserve Bank of India early this month was digested by the markets suggests the increase was fairly well anticipated, as banks had already increased their lending and deposit rates. While fixed deposit holders can hope for better returns on their investments, borrowers will have to shell out more when taking loans.
Yield on the 10-year G-sec rose by 125 bps last year, after the US Federal Reserve started raising its rates. Several other countries increased rates subsequently. Even the 364-day Treasury bill has a yield of 7.09 per cent. Thus, at 6.25 per cent, the repo rate is still behind the curve, so to say, than what market yields have been indicating.
Repo rate is the rate at which the RBI lends money to banks. The RBI generally increases rates to counter inflation by curbing excess demand in the economy, by making it costlier to borrow. Hardening inflationary expectations, mostly due to the spike in crude prices, played a part in increasing interest rates.
Though the RBI hasn’t indicated that this move is the start of a series of hikes, it can be safe to assume that interest rates are set to harden. The present rate increase must push investors in debt funds and fixed deposits to take steps to optimise returns.
Loan takers, too, must opt for suitable re-pricing of their loans, so that the hike does not result in burdensome outflows.
Go for short-term funds
Bond prices and yields move in opposite directions. That is, higher the yields, lower the bond prices. Therefore, bond fund managers need to carefully take calls on the interest rate scenario, and yields and profiles of securities that mature at various times, so that prices don’t fall inordinately and cause losses to investors.
In the last year, as yields on the 10-year G-sec soared, many funds that had bet on securities with a longer duration and maturity profiles of say, five-10 years, have given only marginal returns. In fact, dynamic bond funds and long-term gilt funds reported negative returns over the past six months — their NAVs have declined by nearly a per cent. As interest rates and bond prices move in opposite directions, fund managers in these categories were caught on the wrong foot in managing the maturity profile of their holdings. In general, these funds tend to underperform over the short to medium term when rates rise.
In a rising interest rate scenario, it is better to bet on short or medium-term debt funds — those with one-three years average maturity. These funds have managed to deliver 6.4-6.7 per cent returns on an average in the last one year. Credit opportunities funds, which bet on bonds across the rating curve (AAA, AA+, AA) issued by corporates have also done reasonably well in the past one year, delivering around 6 per cent.
Therefore, investors with a horizon of around three years are better off taking exposure to short/ultra-short and medium duration funds. Corporate bond funds and select credit risk schemes may also be good options.
FDs to become attractive
Several lenders, including SBI, Axis Bank and HDFC Bank, have hiked their fixed deposits by 10-25 bps over the past couple of months. Even NBFCs such as Bajaj Finance have increased rates by as much as 30 bps. Small savings and post-office schemes may be expected to follow suit.
Given that interest rates may take a few quarters to go up significantly, investors may want to opt for FDs with a one-year maturity or a bit more. When rates go up over the next year, as anticipated, interest rates on FDs are likely to rise as well. Investors can then move or roll over their deposits to FDs with higher interest rate options. Thus, they will benefit from the gradual rise in deposit rates.
Home loans costlier
For a ₹50-lakh home loan with a 20-year term, a 25 bps increase (8.5 per cent to 8.75 per cent) means an addition of ₹794 to the EMI. If you are paying higher interest rates, you can consider refinancing loans with providers who offer them at less than 9 per cent.