Interest rates below inflation: Invest or exit?
Though the retail inflation in the month of November 2020 dipped 6.93 per cent from 7.61 of October 2020, it is still above Reserve Bank of India’s (RBI) upper margin of 6 per cent. Inflation reduces the purchasing power and hence, it makes more sense to invest in a space that provides better inflation-adjusted returns.
Having said, equities in recent times have beaten inflation by a considerable margin. However, the same does not hold true with respect to debt. Though fixed income instruments usually bear slightly higher interest rates as compared to inflation yet they are offering significantly lower interest rates.
RBI has been slashing the key policy rates ever since 2018 and is presently, at its historic low. Even though RBI maintained its accommodative stance further, the rate cuts are unlikely to occur. In fact, it is committed towards economic growth and is focussed on bringing the inflation below 6 per cent.
In order to boost the economy, RBI will engage in a few more open market operations (OMO) or operation twists. And this certainly means that the interest rates would be capped. Currently, the rate of interest on government securities is as below.
|
Government Securities
|
|
Period
|
Coupon (per cent)
|
Yield (per cent)
|
|
10-Year
|
5.85
|
5.91
|
|
10-Year
|
5.77
|
5.96
|
|
5-Year
|
5.15
|
5.09
|
|
5-Year
|
5.22
|
5.05
|
|
2-Year
|
3.96
|
3.82
|
|
2-Year
|
5.09
|
3.66
|
|
91-Day
|
N/A
|
3.13
|
|
182-Day
|
N/A
|
3.35
|
|
364-Day
|
N/A
|
3.45
|
Note: 91-day, 182-day and 364-day are zero-coupon bonds
As we can see, the interest rates are way lower than that of inflation. This makes its real rate of return negative. Hence, a lot of fixed income investors might be in a dilemma as to what to do, should they invest or exit their current investments.
We are also aware of the fact that RBI is supporting the economic growth and to do so, it will try to cap the interest rates. Therefore, there are a lot more chances for interest rates to remain low for quite some time. So, if you are a conservative investor, then it makes complete sense to invest in short-term papers with a modified duration of not more than 3 years. However, moderate to aggressive investors can consider investing in medium-term bonds.
Further, aggressive investors can also take credit bets as its yields and spreads continue to remain high, which give investors, an opportunity to get higher accruals. They can also benefit from compression of the yield as the economy gets back on track.