Make the most of rising interest rates

While as consumers,we may be feeling the pain of rising prices,high interest rates augur well for an individual from the investment perspective. Here is how to can take advantage of high interest rates.

The most common route that one would take in case of high interest rates is to park the surplus funds in a fixed deposit. With deposit rates already in double digits,we would logically be tempted to tap this opportunity. Most of us,however,do not take into consideration the post-tax returns from a fixed deposit. If your income falls in the highest tax slab,you would have to pay 33 per cent tax on your fixed deposit gains,resulting in post-tax gains failing to match the rate of inflation.

There are other investment avenues you can consider which tend to be more tax efficient compared to fixed deposits. You can pursue a fixed maturity plan (FMP) which offers excellent post tax returns with very low interest rate risk. In a FMP,the underlying investment is not subject to market fluctuations because FMPs purchase securities with a fixed date of maturity. This makes FMPs a low risk option in a volatile interest rate scenario. Other short term funds also deliver superior returns in a high interest rate scenario such as ultra short term funds.

One needs to be cautious when it comes to the medium to long term though. Funds of this duration range carry significant interest rate risk since bond prices share an inverse relationship with interest rates. Investors having a long-term investment focus and investing in longer duration funds such as income and gilt funds should do so with an investment horizon of at least 1-2 years. This is critical since the rate cycle is expected to reverse in the coming months. As and when this happens,the Net Asset Value (NAV) of these funds will decline.

This can be explained with an example. Say you have invested R 10,000 in a 5 year bond,yielding 10 per cent. If the interest rates move up,bonds will get issued at higher coupon rate,say 11 per cent. The old bond which you purchased at 10 per cent will become less valuable. As such,there are risks attached to medium to long duration fixed income funds.

Investors with a medium to long term perspective should not get perturbed by volatility in interest rates. The prevailing high interest rates would offer excellent returns as the return generated by the fund includes both interest earned as well as capital gains due to interest rate movement.

Income funds are a better choice for fixed income instruments when interest rates peak and when the rate cycle reverses since there will be fall in yields delivering superior returns. It is essential to build a well-diversified fixed income portfolio when interest rates are peaking,for it impossible to time reversal in inflation and interest rates.

As the global recovery combats new headwinds and key growth drivers in the economy show signs of weakness,inflation drivers such as demand and commodity prices could subdue leading to the much required decline in inflation.

In such a scenario,bonds will do extremely well and given their current levels at close to three year highs,probability of yields falling is higher. This presents an excellent case for investors to start building a medium to long duration fixed income portfolio.

— Author is Fund Manager – Fixed Income,Mirae Asset Global Investments India.