Investing in a rising interest rate scenario 

Inflation has risen across the globe to become a pain point for policymakers who grapple with rising prices and faltering economic growth. Things seemingly turned worrisome when the Reserve Bank of India (RBI) raised the repo rate by 40 basis points on May 4 and again on June 6.  

Change in this key rate has expectedly led to a rise in interest rates. While we understand that this increases borrowing rates, it also affects your investments. 

With the growing interest rates, should investors like you need to worry? What should be your strategy towards investment during such times?  First, let’s revisit the connection between inflation, interest rate, bond yields etc.  Inflation and interest rates are directionally related, i.e. they tend to move along the same trend but with some lag. 

RBI and other central banks desire positive but manageable inflation rates. A negative inflation rate or deflation means degrowth in the economy because with rapidly decreasing prices, consumers tend to pause/postpone their spends leading to slowdown in economic activity. 

Fundamentally, the supply and demand for money determine inflation. If money supply increases i.e. more money is chasing the same goods, inflation increases, and if money supply decreases so do prices and inflation. 

Change in interest rates has the effect on controlling the supply of money in the economy. 

When interest rates are increased, the cost of borrowing rises. It makes borrowing expensive. Hence, borrowing decreases, and so does the supply of money.  

In a low inflationary situation, the rate of interest reduces. A decrease in the rate of interest will make borrowing cheaper. Hence, borrowing will increase, and the money supply will increase. With a rise in the money supply, people will have more money to spend on goods and services. So, the demand for goods and services will increase, and with supply remaining constant, this leads to a rise in the price level, which is inflation.  

Due to the prevailing tensions in the west courtesy the Russia-Ukraine war, commodity prices have steadily increased and inflation continues to skyrocket. In hindsight, inflation is likely to remain over and above the RBI’s current target.  

Hence, the RBI has increased interest rates to control inflation, further worrying the bond market. This is why the bond yields rose to 7.4% when the central bank announced the rate hike. 

Impact on Stock Market 

It is a known fact that equities are sensitive to any change in the interest rates. Moreover, the two functions are inversely correlated to each other. That is, the price of stock increases when the interest rates fall, and vice versa.  

However, the below chart albeit dated shall help you understand that there is a lag effect when stock market reacts to changes to the interest rates. For instance, though the RBI started to hike rates from January 2010, the stock market continued to soar for some time, before the high rates of borrowing starts to hurt earnings.  

Impact on Debt  

Bond prices and interest rates are inversely proportional i.e. when interest rates go up, prices of existing bonds fall. Further, an increasing interest rate affects every kind of debt instrument. But the impact is more severe on the medium to longer duration debts than the shorter ones. This is because the price fluctuation is very low in short-term instruments.  

Hence, debt instruments that invest for a shorter period perform better in a rising interest rate scenario. On the other hand, medium and long term debt instruments witness a price correction.  

Impact on Equity Investments  

With a rise in the interest rates due to inflation, banks are compelled to hike their lending rates. This increase in lending rate further pushes up the cost of capital for businesses and organizations, further impacting the financials of the companies. 

The cost of debt is represented by the 10-year bond yield of the government. If yields rise, it’s thus natural for the cost of capital to increase too. This further lowers the returns to make equities unattractive.  

Hence, when a rate hike looks imminent, equity markets have corrected at around 6% in a few trading sessions. Earlier too, we saw how Indian bond yields recorded a historic high of 9% in August 2012, further rocketing up to 22% in a month. This led to a stock market correction of 9%.  

Impact on Real Estate Investments 

As is seen in the past, whenever the interest rates go up, property stocks tend to lose value at least 60% of the time. Higher interest rates make acquisition costs of new assets more expensive if real estate expansion is financed through borrowings.  

Further, rising interest rates can increase the cost of capital of real estate investment trusts (REITs) further resulting in higher cap rates. A high cap rate can also lower the net asset value of REITs, leading to a stock price fall.  

Where to Invest in a Rising Interest Rate Scenario?

Accumulate Cash: In the current scenario, bonds are being sold off due to fears that the central bank will start tapering off its bond buying program. This is why the interest rates are rising. When the rates rise very quickly, equities begin to be sold off as well amid the fears of higher opportunity costs and slowing consumption. 

During such times, cash becomes even more valuable while the other asset classes decline. It’s always good to have a healthy cash stack to start investing back into equities and bonds once you’ve recognized your risk tolerance. 

Invest in short duration funds: You may want to lower the average duration of asset holding with the aim of reducing your portfolio’s sensitivity. When you plan on investing in a rising interest rate environment, you should consider bond funds with coupon rates that float with the market rate.  

Get your borrowings under control: Rising interest rates lead to an increase in the cost of being in debt. Do you have variable-rate debts or debts that will push you to borrow more to pay off at maturity? Now is the right time to figure out ways to pay them off or lock in fixed rates for them. Variable-rate debts will become expensive with every increase in the interest rate. This will further make it expensive to opt for fixed-rate loans.  

By paying your debts or financing it while rates are fairly low, you can control more of your income and cash flow. This helps in ensuring that you have enough money available to invest in the first place.  

Allocate towards alternative investments:  Investors can consider investing in alternative assets. Alternative investments are not market-linked and hence reduce volatility to a greater extent. Alternative investments like peer-to-peer lending has been proven to be a good way to brace from stock market correction. Besides, it also offers high yields despite a rising interest rate scenario. Besides P2P lending in India, investors can explore invoice discounting, fractional real estate and more but should attempt to stay away from companies and sectors that are negatively impacted by rising interest rates. 

The author is CEO of IndiaP2P, a platform high-yield fixed income investments