If interest rates have peaked out…

Aarati Krishnan | Updated on December 26, 2011

A halt to rising interest rates would mean that investors should lock into term deposits and stay away from fixed rate home loans.

It is seldom that investors have advance notice of events that can change the direction of the markets — a landslide election win, a favourable policy shift or an influx of foreign money. That is why the RBI's indication in its latest policy review that it may call a halt to rising interest rates is so important for investors.

Projecting that inflation rates may subside to 7 per cent by March 2012, it has said that the possibility of further rate hikes in the December policy review is “relatively low”. Though there is a big if attached to this projection, if interest rates are set to peak out shortly, there is a lot that investors must do:

Lock into term deposits

Steadily rising interest rates and banks scrambling for deposits have made for some great opportunities to earn double-digit returns on such cast-iron investments as bank deposits. However, that opportunity may not last very long. If the RBI pauses in its rate hike spree, deposit rates may not climb much further.

Yes, banks may take one more round of deposit rate hikes over the next few weeks. But that would be a good time for investors to lock into fixed deposits for 3-5 year tenures from banks or with a three-year perspective in triple-A rated companies. When the RBI called a halt to its rate hikes last time, in end 2008, interest rates on 3-year deposits from top banks tumbled from 9.75 per cent to 6.5 per cent within a year. Rates are unlikely to fall so sharply or quickly this time, but catching the top of the rate cycle can be tricky.

If interest rates are close to peaking out, rates on loans too will follow suit. That makes this a bad time to sign up for large loan obligations such as home loans. Also avoid fixed or fixed-floating rate loans entirely.The best time to take a fixed rate loan is after rates have fallen steeply.

Take another look at stocks

Finally, the prospect of interest rates topping out may be a turning point for the equity market. Steadily rising interest rates are never good for stocks, for two reasons. One, is the constant trade-off that all investors make between debt and equity investments for their portfolio. A higher return on the safer debt investments automatically means that investors would demand higher returns from equity, which carries much higher risk. This means that they would like to buy stocks only at lower valuations. Both lay investors and foreign institutional investors have actually been making this trade-off in favour of debt this past year. Statistics from different sources show the bulk of incremental savings flowing into bank deposits and safe investments. SEBI data show that so far this year, FIIs pulled out Rs 292 crore on a net basis from equities, but parked Rs 18,000 crore in debt instruments. Now, a big shift in this allocation from debt to equities may only happen if interest rates begin to climb down. But incremental allocations both from households and the FIIs may go into stock markets if rates are seen to be plateauing from here. Two, profits of Indian companies, especially small and mid-sized ones, do tend to be quite sensitive to borrowing costs. Interest costs, which rose sharply year on year, took away about 12 per cent of the operating profits for the non-finance companies in the CNX 500 in 2010-11.

Who will benefit

A study of the CNX-500 companies shows select sectors to be more sensitive to interest costs than others — construction companies (interest costs were 38 per cent of operating profits in 2010-11), gems and jewellery (33 per cent), hotels (29 per cent), infrastructure and power generation companies (25 per cent each) and realty and retail (26 per cent). Though these sectors will face the spill-over effects of recent rate hikes, they can look forward to some relief from further interest rate hikes six months down the line.

For companies in these sectors that manage to keep their profits expanding over the next couple of quarters, the interest outgo will eventually begin to hurt less. Given that many of the above sectors, along with banks and finance companies, have been beaten down the most in the recent market correction, they are available at single-digit price-earnings multiples. These stocks could see some bargain hunting if the markets believe that interest rates will not head higher.

Published on October 29, 2011

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