The Hindu Business Line : What peaking interest rates mean for investors

While the interest rate scenario calls for caution on borrowings, the time is probably ripe to invest in debt options that can help you lock into the higher interest rates prevailing now.

Aarati Krishnan

When the RBI meets for its policy review next week, will it call a halt to the series of interest rate increases that it has put through over the last one year? Consensus is building in the markets that it will. Indeed, a softening of yields in the bond markets is already signalling that interest rates may gradually ease from the peaks reached earlier this year. What could be the consequences of such a trend?

Rates on hold?

After a series of lending rate increases over the past one year, banks and other financial institutions look to be switching gears to either hold or marginally reduce their lending rates over the next few months. Corporation Bank, for instance, has announced a 25 basis point reduction in its home loan rates for tenors up to 15 years. Though other larger lenders are yet to follow suit, the RBI’s forthcoming review would be watched keenly by banks for cues on lending rates.

Interest rates on bank term deposits may also cool off from their earlier highs. The liquidity crunch in March had forced several banks to roll out special deposit schemes that offered interest rates that were as high as 10.75 per cent for specific one-two year terms. Such options may now shrink, as banks are faced with surplus liquidity and fewer avenues for deployment of their funds, as credit growth slows. Yields on market related debt options such as fixed maturity plans offered by mutual funds have already declined substantially from their peak in March.

What are the implications of steady or declining trends in interest rates for individuals and investors?

Caution on home loans

To start with, those planning purchases of large assets funded through loans should consider putting such purchases on hold, until clarity emerges on the interest rate scenario. This is especially true for home loans, where even a small drop in borrowing rates can significantly cut the tenure of your loan. For instance, a 25 basis point drop in interest rates on a loan contracted at 11 per cent, can reduce the tenure of a 15-year loan by as much as a year.

With interest rates set to stabilise or even drift down gradually, investors should, first and foremost, avoid contracting fresh loans at the prevailing fixed rates of interest. Interest rates on fixed rate loans are currently pegged substantially higher than those for floating rate loans. Therefore, locking into fixed rates at this juncture could prevent investors from taking advantage of any subsequent softening in lending rates and leave them saddled with a higher loan obligation than necessary.

Floaters better

On the other hand, caution would also be warranted while contracting fresh floating rate loans, especially if the loan size is substantial in relation to your overall portfolio or savings. Given that there is usually a significant time lag before market changes in interest rates get reflected in banks’ lending rates (especially for retail borrowers). The above counsel would hold true more for home loans. If property prices stabilise and or even cool off in select pockets, home purchasers signing deals today may be faced with twin risks of higher loan obligations and declining property prices. (However, the flip side of this argument is that delayed purchases could result in missed opportunities if property prices continue to soar.)

Time to Lock in

While the interest rate scenario calls for caution on borrowings, the time is probably ripe to invest in debt options that can help you lock into the higher interest rates prevailing now. This may call for a rejig of your fixed income portfolio. Fixed Maturity Plans (FMPs) from mutual funds (closed-end debt funds that invest in bonds with a fixed term), which were the top investment options in the debt space last quarter have dwindled in number and now offer lower yields.

After peaking at over 10.50 per cent in March 2007, the indicative yields on shorter term FMPs have declined to 6-8 per cent levels of late. While FMPs continue to score on tax efficiency, investors will have to adopt a selective approach between various FMPs based on the yields on offer.

The special deposit schemes that quite a few banks continue to offer also appear to be windows of opportunity for investors looking to capitalise on prevailing interest rates. With many banks in a surplus liquidity situation, there may be an eventual shrinkage in “islands” offering high interest rates such as special deposit schemes.

While the time may be right to lock into options such as FMPs and term deposits, investors may watch for further cues on an actual cut in policy rates, before moving funds significantly into debt options such as gilt or long term income funds, which are usually the biggest beneficiaries of any steady decline in market interest rates.

Steadily declining yields usually result in a run up in bond prices, which are captured as capital appreciation in the Net Asset Values (NAVs) of gilt and income funds. Such income and gilt funds, which offered high returns of 12-14 per cent annualised in the period up to 2004, have been ignored by investors over the past few years, as the interest rate cycle turned.

Though such funds have already recorded an improvement in returns in recent weeks on declining market yields, sustained recovery in returns will hinge on interest rates continuing their downward journey.

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