Planning Investments In A Falling Interest Rate Scenario

With the key interest rates finally budging, it’s time to make strategic changes in your investments, advises Hemant Rustagi.

After making everyone wait for nine long months, the RBI has finally cut the repo rate by 0.25 per cent to 7.75 per cent and the Cash Reserve Ratio (CRR) by a similar margin to four per cent. These initiatives are aimed at encouraging investments, supporting growth and anchoring inflationary expectations. The RBI has also clarified that if inflation and the Current Account Deficit (CAD) moderate further, there will be room for monetary policy easing.

However, we will have to wait and see whether these factors indeed provide more elbow room to the RBI or not. Even if the RBI does not get enough leeway for further easing in the near future, the longer-term trend appears to be in favour of benign interest rates.

In the emerging scenario, there would some challenges and opportunities for investors. Here is what is in the offing:

Cheaper Housing Loans: Although the National Housing Bank (NHB) has already set the pace for reduction in housing loan rates by reducing its benchmark lending rate by 0.25 per cent, other banks and housing finance companies may take some time to follow suit. However, for all those who have waiting to buy their dream home, it may soon be time to act.

Existing borrowers also need to keep an eye on how their lenders react. If the benefit of lower interest rates in not passed on to them and the remaining tenure for repaying the loan is long enough, it would be advisable to get the loan transferred to another lender. Of course, the difference in interest rates has to be attractive enough to make the shift. Although banks cannot levy any penalty for pre-payment of the housing loan, the conversion fee charged by the new lender also needs to be considered before making a decision.

Impact On Investments: Investors usually have two types of instruments in their debt portfolios, i.e. traditional options like FDs, bonds, debentures, Employees’ Provident Fund (EPF) and Public Provident Fund (PPF), as well as market-linked options such as debt mutual funds.

A fall in the interest rate usually impacts the traditional and market-linked instruments differently. While traditional instruments start offering lower returns, the market-linked instruments, especially longer duration income and gilt funds, benefit due to an inverse relationship between interest rates and bond prices.

However, considering the liquidity crunch in the system and the slow deposit growth over the last one year or so, many banks may not reduce the deposit rates immediately. Therefore, for those who wish to invest in bank FDs, it is a good opportunity to lock in money at the current rates. However, FDs are not a tax efficient investment option, especially for those who fall in the higher tax bracket of 20 and 30 per cent.

For tax-paying investors, debt funds could prove to be a good option in the emerging interest rate scenario. Of course, the key would be to select the right fund depending on one’s time horizon.

The major differentiator between different types of debt funds is the maturity duration of their portfolios. For example, for an individual who has a time horizon of a year or so, short-term debt funds would be an ideal option. For a time horizon of 18-24 months, income funds would be the right choice. However, in the latter category, one has to be a little careful in choosing funds. While income funds with a longer maturity duration will have the potential to perform well if the RBI continues with monetary easing over the next 12 months or so, there are attendant risks too.

In case the rate cuts do not happen in the manner envisaged by the market, investors will have to encounter increased volatility as well as the risk of lower returns. Keeping these risks in mind, it may be prudent to opt for dynamic bond funds. Dynamic bond funds are those funds where the fund manager manages the duration of the portfolio actively, depending on the interest rate movements.

Fixed Maturity Plans (FMPs) can also be a good option for investors who are tax payers and do not want volatility in the returns. An FMP of 15 months or so will also allow investors to avail themselves of the double indexation benefit. However, if the Direct Tax Code (DTC) is implemented, investors may not be able to enjoy the double indexation benefit.

Hemant Rustagi
CEO, Wiseinvest Advisors