How do interest rates affect your investment portfolio
Every year the Reserve Bank of India (RBI) changes the interest rates in the country using its monetary policy. This affects a number of industries. You know that loan rates change. However, do you know that your investments get affected too? Interest rate dynamics play a role in every one of your investments. Let me first tell you why the RBI has been cutting interest rates.
Why the rate cut?
Lower interest rates encourage additional investment spending. This gives the economy a boost in times of slow economic growth. Lower interest rates translate to lower loan rates and this encourages industries to borrow and invest the money in running their business. When businesses do well, the economy does well. Simple enough?
So, the RBI uses the monetary policy to keep the economy in shape. When the economy is growing and in good condition, RBI takes measures to increase interest rates slightly to keep inflation at bay. RBI controls the repo rate, which influences long-term interest rates in the country. Repo rate is the rate at which RBI lends money to commercial banks in the event of any shortfall of funds.By setting the repo rate, the RBI indirectly adjusts long-term interest rates, which increases investment spending and eventually helps encourage employment, production and economic well-being.
How this affect your investments?
For investors, change in interest rates can have significant portfolio implications, specifically for income investors who prefer bonds/bond funds. Bonds and interest rates have an inverse relationship. That means when interest rates rise for an extended period, bond prices will decrease. When interest rates fall, bond prices will increase. Change in rates can directly impact bond yields. Long-term bonds that have maturity terms ranging from 10 to 30 years will have substantial effects. Short-term bonds may be less affected by interest rate changes.Newly issued bonds will have higher coupon rates after interest rates rise, making bonds with low coupon rates worthless.
If you have bond holdings in your portfolio, such as fixed deposits, liquid funds or money market funds, falling rates mean a lower return on your investment. As rates fall, banks tend to offer correspondingly lower rates on deposit accounts. The rates for debt mutual funds will fall too. If there is an increase in interest rates, deposit rates and fund rates will go up.However, understand that interest rate changes impact you, as an investor, only if you are going to redeem your bonds/bond funds.Learn how to mange your money & create wealth, Download your FREE eBook now
Let’s say you purchased a bond for Rs. 1,000. The RBI raises the interest rate and this decreases your bond’s market value to Rs. 900. So, the paper loss is Rs. 100. This loss is only on paper. If you hold this bond to maturity, you will still receive Rs. 1,000, barring a default by the issuer.
Another point is that these interest rates fluctuations will not affect you if you are a long-term investor.Short-term interest rate changes do not affect the long-term outlook. Bond price decreases will be offset by bond price increases at a later date. Staying invested and diversifying can help to preserve your overall investment portfolio against the effects of changing interest rates in the long run.
In contrast to bonds, interest rate changes do not directly affect the stock market. However, RBI’s actions can have a trickle-down effect that impacts stock prices. For instance, when the RBIcuts interest rates, banks cut their rates for consumer loans. In theory, this means there’s more money available for consumer spending.
Also, lower rates for business loans can lead to businesses expanding and doing well. Increased consumer and business spending together can increase the value of a company’s stock.When RBI raises interest rates, banks increase their rates for loans. Also, increased rates for business loans can cause companies to halt expansions and hires. Reduced consumer and business spending will lower the value of a company’s stock.
Still, there’s no guarantee that a rate cut will positively impact stocks or a rate hike will increase stock prices. For instance, falling interest rate occur during periods of economic slowdown. In this scenario, reduced rates often coincide with a bear market.So, the impact of the interest rate changes will depend on the company you chose to invest in.
Commodity prices increase when interest rates fall and prices may fall when interest rates rise. This suggests that an interest rate hike sometimes creates an unfavourable climate for these investments and vice versa. For instance, gold prices touched an all-time high in India after RBI cut interest rate.
If you have holdings in real estate, an interest rate cut can be beneficial. Real estate prices are directly linked to interest ratesdue to the cost of financing and some bond-like characteristics such as regular income payments. The relatively steady stream of income generated by real estate becomes more attractive as interest rate fall.
What should you do?
Bonds and interest rates have a straightforward relationship, but it’s much more difficult to predict how rates will affect stock and other investment returns. Because interest rate changes can affect investments in different ways, there is no single action you can take when they change. Knowing how to manage your portfolio during periods of rate changes can help to mitigate any potential negative effects.
The first step is understanding your portfolio and how individual asset classes are likely to be impacted by the interest rates. Depending on how your portfolio is structured, you can decide whether you should take any action for an asset class.
The second step is to analyse each investment. If you have more investmentsin stocks, try and analyse the sectors that might get impacted by interest rate changes. For instance, cyclical industries such as financial institutions, industrial companies, and energy providers tend to perform better when rates rise. Real estate investment trusts, utilities, consumer staples, and telecommunication, might perform well when rates fall. So, research each investment when interest rates change.
Find this tough? Then, just build a diversified portfolio made up of quality stocks, bonds, and cash equivalents. The smartest thing investors can do is mindfully manage their portfolios to limit the downside and increase potential upside as interest rates and the market fluctuate. Diversification is the best way to do that.With a balance of stocks and bonds, your portfolio may be better positioned to maintain more stability despite interest rate changes.
So, you need to stay focused on your financial goals and stick to your financial plan. You could leverage tools such as Mymoneysage.in to understand how you can minimise your portfolio risks. Mymoneysage can help you construct a portfolio that is diversified enough to help weather any short-term effects of a rate change.