Investing in rising interest rate scenario

The Reserve Bank of India (RBI) has maintained status quo on the interest rate front during the last two quarterly reviews. On both the occasions, investors had expected the RBI to reduce the interest rates by at least 25 bps, but the central bank did not oblige. The RBI cited inflation as the factor for not reducing the interest rates.

Now, going forward, the prospect of increase in the inflation will be all the more pronounced as the prices of crude oil prices are spiralling upwards, which will have a cascading effect on the prices of goods and services. Moreover, the years 2018 and  2019 are election years, with nine states going to the polls during 2018 or early 2019, culminating with the Lok Sabha elections in April-May 2019. Since all these elections will entail huge amount of expenditure by the state governments for assembly polls and the Central government for the Lok Sabha polls, apart from expenditure by political parties and tens of thousands of candidates, the inflation is only going to spiral upwards.

The Central government is also likely to incur massive expenditure on infrastructure projects as also on the social sector initiatives in the run-up to the 2019 Lok Sabha elections, which is likely to derail the government’s fiscal deficit target. The higher government spending will increase the fiscal deficit and higher fiscal deficit will provide fuel to the fire of inflationary spiral.

Under these circumstances, the RBI, instead of cutting interest rates, is more likely to raise them to suck out the excess liquidity in the system and contain the inflationary spiral.

Now, if the RBI is going to raise interest rates in 2018 and 2019, what kind of investment strategy should the investors adopt to take advantage of the rising interest rate scenario? If the interest rates rise, investors would do well to exit stocks of companies with high leverage as the interest outgo of these companies is likely to go up, which may lead to a decline in the bottomline. Also, if a company has undertaken greenfield or brownfield expansion on borrowed funds, the cost of the expansion project would go up, so the stocks of these companies are likely to witness a downtrend till the new facility becomes fully operational. Hence, it is better to avoid or exit such stocks.

On the debt investment front, rising interest rates are a boon for investors in bank fixed deposits (FDs) and company deposits (CDs). These investors would be getting higher interest pay-outs, provided they invest after the interest rates on the deposits are hiked by banks and corporates. Till that time, one can go for short term (tenure of 6 months to a year) FDs and CDs, so that when the rates go up, the matured FDs and CDs can be reinvested at the higher rate. However, for investors in bonds and bond funds, hike in interest rates would lead to decline in the value of their bonds as when the yields on bonds go up (due to hike in interest rate), bond prices fall. So, while investing in bonds, it would be better to invest in short term bond funds that focus on accrual.