The relative calm with which the 25 basis points rate hike by the RBI was digested by the markets suggests that the increase was fairly well anticipated with banks already having raised lending and deposit rates over the past few months.

The yield on the 10-year G-Sec has already risen by 125 basis points in the last one year after the US Federal Reserve started raising rates – several other countries have increased rates subsequently.

Even the 364-day treasury bill is at nearly 7 per cent.

Thus, at 6.25 per cent, the repo rate is still behind the curve, going by what market yields have been indicating. Hardening inflationary expectations, mostly due to the spike in crude prices, too, 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 safely assumed that interest rates are set to harden.

Investors in debt funds and fixed deposits should therefore take steps to optimise returns.

Short-term funds

In the last one year, as the yields on the 10-year G-Sec soared, many funds that had bet on securities with longer duration and maturity profiles – 5-10 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. 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 have managed to deliver 6.4-6.7 per cent returns on an average in the last one year as a category.

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 shorter horizon of around three years, would be better off taking exposure to short- and medium-duration funds. Corporate bond funds and select credit risk schemes may also be good options.

FDs to become attractive

Several banks, including SBI, Axis Bank and HDFC Bank, have hiked their fixed deposits by 10-25 basis points over the past couple of months. Even NBFCs such as Bajaj Finance have increased rates by as much as 30 basis points. 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 would be better off opting for FDs with a one-year maturity or a bit more. Investors would be better off not locking into longer-term FDs for now.

When rates go up over the next one year, as is anticipated, interest rates on FDs are likely to rise as well. Investors can then move or roll over their deposits to FDs to higher interest rate options.

For a ₹50-lakh home loan with a 20-year term, a 25-basis-point increase in interest rate (8.5 per cent to 8.75 per cent) would mean an addition of ₹794 to the EMI.

If you are paying higher interest rates, you can still consider switching loans with providers who are offering them at less than 9 per cent.