How to profit from interest rate hikes

How to profit from interest rate hikes

On 16 September, the Reserve Bank of India (RBI) increased the key rates. While the repo interest rates. While the repo rate (at which RBI lends money to banks) has gone up by 25 basis points, or bps, (one basis point is one-hundredth of a percentage point) to 6%, the reverse repo rate (at which RBI borrows from banks) has been hiked to 5%.

 

So, what does it mean for you--should you feel happy or sad? While some experts say home loan rates will rise, others say deposit rates will go up.

Cutting through the noise of how this would impact the economy and the way banks borrow and lend their money, we answer some of your concerns as an investor as well as a borrower.

The investor Rising interest rates All through the credit crisis that gripped developed countries--including India, though not to a large extent--globally, central banks kept cutting interest rates. India is now firmly witnessing a rise in interest rates. Inflation has been rising steadily. Data provided by Bloomberg shows that inflation is now at 8.5% as on end of August, up from 0.3% just a year back. Interest rates have risen in order to curb inflation.

 

Although rising interest rates are not good for long-term debt funds (interest rates and bond prices--and therefore the net asset values of bond funds that invest in them--move in opposite direction), some investment options benefit from rising interest rates. We suggest you take a look at bank fixed deposits (FDs) and debt funds with short tenors, such as fixed maturity plans (FMPs) and short-term bond funds.

If you are risk-averse For up to a year, look at FMPs: Ever since RBI mandated banks to lend money to corporate borrowers not below the base rate (the floor rate at which banks can lend money plus a few percentage points accounting for expenses), base rates of most banks range between 7.5% and 8.5%. Many companies have started issuing commercial papers, or CPs, (a debt paper issued by companies to borrow money for short-term needs) as they find it expensive to borrow it from banks at base rates.

 

Data provided by RBI shows that as on 31 July, the total amount outstanding on CPs issued amounted to `1.13 trillion, up from `77,560 crore a year back. These days, CPs offer 6.10% to 9.00%, up from 3.04% to 8.85% a year back. Data provided by Bloomberg shows that a three-month CP offers an interest rate of 7.55% these days, up from 6.63% in June and 4.68% in April. The rates for one-year government securities have also gone up to around 6.25%, up from 4.95% in the beginning of June.

 

Here's where FMPs come in.

These are closed-end debt schemes launched for a specific period and they invest in fixed income securities, such as CPs.

"It makes sense for mutual funds to invest in these CPs as there are chances to get the benefit of higher yields and offer the same to investors," says Vikrant Mehta, fund manager (fixed income), AIG Global Asset Management Co. (India) Pvt. Ltd. According to data provided by Value Research, a mutual fund tracking firm, 80 FMPs were launched between June and August that collected around `7,337.91 crore, up from just 12 FMPs launched between April and May that collected `478.53 crore.

 

These days, typically, MFs are launching FMPs for tenors of three months and a year, though FMPs are launched for other time periods too. Since FMPs come with a specific tenor, they invest in securities that mature a little before they themselves mature. For instance, a three-month FMP would invest in only securities that mature a little before three months.

 

Although FMPs aren't allowed to give indicative returns, market sources say that a typical three-month FMP, if invested in at these levels, would return around 7% after three months minus expenses. They add that a one-year FMP, if invested in at these levels, would return around 7.5% to 8% after a year. If you invest in a threemonth CP and are in the highest tax bracket (30.9%), you would earn 6.03% after taxes, assuming you invest in a dividend reinvestment plan (7% less dividend distribution tax of 13.84%). Debt funds pay a dividend distribution tax at the time of distributing dividends. Remember, to be able to get these returns, you need to stay invested in them till maturity. Premature redemption will impact your returns, adversely. A threemonth bank FD would yield 6% on the higher side. For investors in the highest tax bracket, this yields 4.20%.

 

Mahendra Jajoo, head (fixed income), Pramerica Asset Managers Pvt. Ltd, feels that one could invest in ultra short-term funds for about three-four months and then switch to FMPs that are launched in January. "Since short-term rates are still rising, investing in FMPs at these levels may result in a lost opportunity. Besides, FMPs launched during January and before March 2011 will offer double indexation benefits," he adds.

 

For one year to five years, look at bank FDs: Though depositors have seen a slight hike in interest rates in the recent past, the real rate of return (inflation-adjusted returns) are still negative. And this has been RBI's concern. Its mid policy statements clearly indicate that the real returns on bank deposits should be positive. Banks are expected to hike FD rates soon and most experts believe the increase will be 25-50 bps. Salil Datar, head (branch banking and non-resident Indian business), Dhanlaxmi Bank Ltd, says: "The returns on FDs are below the rate of inflation. Historically, bank deposits have grown by 20-24%. This has come down to 14% in the first five months, so far this year. As a result of this poor growth, interest rates on FDs are bound to go up."

 

Currently, the rates are pegged around 8% per annum on five-year FDs, but because of the tax incidence, the effective return is only around 5.6% per annum for those in the highest tax bracket. If you are in the lower income-tax bracket or you have no tax liability, bank FDs are a good option. This is best suited for senior citizens who are looking at liquidity, have minimal tax liability and get 50 bps extra. Assuming that the senior citizen earns 50 bps extra, the above FD would fetch him 8.5% per annum. If he is in the lowest tax bracket, his posttax return would be 7.65% per annum. Watch out for a penalty on premature withdrawals imposed by some banks.

If you can take some risk For five months to one year, look at short-term bond funds: These are debt funds that invest their corpus in fixed-income securities maturing between six months and up to two years.

Though short-term bond funds have given low returns so far this year (an average of 3.54% in the past nine months), those that have a low average maturity of about less than a year or so, would benefit as they would reinvest a portion of their corpus in debt papers at present yields.

 

These funds would also be less volatile from interest rate fluctuations compared with debt funds with a longer tenor that experience volatility when interest rates rise. Says Dhawal Dalal, head (fixed income), DSP BlackRock Fund Managers: "Overall, FMPs are attractive than short-term bond funds at these levels. In a rising interest rate scenario, actively managed funds have to keep their average maturity low and, hence, their returns are typically lower than FMPs."

 

For more than one year, wait and watch: Avoid longterm bond funds for now, but look out for them after about three months. Some debt fund managers say that long-term bond funds may become lucrative sometime in December 2010 and January 2011. With inflation appearing to stabilize, if not fall, and India growing at about 8.5%, RBI seems to be satisfied with the impact generated by frequent interest rate hikes it has undertaken since October 2009. "The Reserve Bank believes that the tightening that has been carried out over this period has taken the monetary situation close to normal," said its 16 September policy statement.

 

"This means that if inflation has reached a plateau, RBI may become less aggressive on interest rate hikes. The yield of the benchmark 10-year government security is currently around 7.95-8%," adds Mehta.

He feels that the 10-year benchmark yield, typically looked at as a benchmark for long-term rates, doesn't look like it can go up significantly from these levels. Long-term bond funds benefit when long-term interest rates fall.

The borrower Will lending rates rise? With RBI hiking policy rates, banks are now expected to follow suit.

Says Allen Pereira, chairman and managing director, Bank of Maharashtra, "We will see that very soon, that's by the end of September, banks too will hike their lending rates. This is a signal that cost of funds and lending rates will go up." There is a strong possibility that base rate will go up by 25 bps, he added.

Base rate is the rate below which banks cannot lend. As mentioned above since deposit rates are expected to rise, that will increase the cost of funds for the banks, who will then have to hike their base rate. This means that most of your loans will become more expensive.

While your equated monthly instalment (EMI) may not increase, the tenor surely will.

 

How will it affect you? If you have a floating rate home loan under the base rate, your interest payout will go up. Bankers expect the base rate to rise by 25-50 bps. So, if you are on a base rate of 8% plus a 2% margin, your current interest rate is 10%. If the base rate rises to 8.25%, your interest rate will automatically go up to 10.25%. So, be prepared to shell more funds for that loan either through higher EMIs or through increased loan tenor. If you are on the older benchmark prime lending rate (BPLR) system, the verdict is mixed. While some experts don't think there will be a rise in interest rates since most banks saw a hike in BPLR just a few weeks back, but others do not rule out this possibility.

 

If you are into a teaser loan, you will obviously not have to worry about rising interest rate scenario for at least a few years.

Says Harsh Roongta, CEO, Apnapaisa.com, "If you are looking for a new home loan and looking for a teaser, the rate rise will not affect you for two years."

 

Should you prepay? A home loan comes under the category of "good" loans because it works against inflation and both the principal and interest portion qualify for tax deduction.

So, if you have surplus funds, you need to work out the numbers to see whether prepayment makes sense for you; it's possible that investing the money would work better.

 

For instance, if you are in the highest tax bracket, a home loan with an interest rate of 12% per annum will actually cost you 8.29%. On the other hand, investment in risk-free, guaranteed Public Provident Fund will give you 8%, which is less than your interest outgo on the loan.

So, it would make sense for you to prepay the loan. But if you have a home loan with a lower interest rate, you may not want to prepay.

 

"If you have enough emergency funds, savings and investment in place, and all your other expensive loans are paid off, it's best to prepay the home loan with extra funds in a rising interest rate scenario," says Roongta. Remember to take into account the prepayment penalty. Typically, public sector banks do not impose this penalty but some private banks do.

The prepayment strategy changes for high networth investors who are able to leverage their money better and are able to factor in the impact of inflation reducing the real rate of interest over time.

 

Once you are armed to take on the rising interest rates, take a stride that'll take your financial life forward.