Real Returns. How low can rates go?

The RBI has pulled a rabbit out of its hat by cutting policy rates earlier than many people expected. Now that the interest rate cycle is beginning to reverse, how should you plan for its impact on your finances?

To do this, you will need to know how much further interest rates could fall from here.

History can be a good guide. Looking back at the Indian rate cycles over the last 15 years, there are two key trends that are relevant to investors.

A rate-cutting cycle, once flagged off by the RBI, usually lasts for a year or two, unless interrupted by a crisis. Plotting India’s policy rates over the last 15 years, there were three falling rate phases. The one which unfolded from April 2001 to March 2004 lasted three years.

The second one from October 2008 lasted six months. The third, from March 2012 to July 2013, was cut short by unusual depreciation in the rupee, which forced the RBI to back-pedal.

Market conditions today suggest that the current declining rate cycle may be gradual and likely to extend over a year or two, barring a crisis.

Accepting that rates will slide down gradually over the next year or two, how much lower can they go from here?

Experience suggests that policy rates have room to decline by 200 basis points or more, if this cycle plays out as expected. The RBI’s current repo rate of 7.75 per cent is closer to the peak of previous rate cycles (9 per cent) than the bottom (4.75 per cent).

In the last three rate-cutting cycles, policy rates declined by 300-475 basis points from peak to trough.

The above factors may suggest that investors today have plenty of time to overhaul their debt portfolios. After all, with the RBI just taking the first baby step towards cutting rates, don’t we all have six months to a year to digest and act on it?

We may not, because the bond markets, much like the stock markets, tend to factor in rate actions by the RBI much ahead of the event.

Though the central bank’s announcement last week was supposed to be a surprise, the bond markets had already factored in a good portion of this rate cut before. Therefore, by the time the RBI’s 25 basis point cut was announced, the yield on 10-year government securities had already fallen from 9 to 7.8 per cent. Gilt and income funds, which had anticipated the fall and stocked up on long-term bonds, were already sporting one-year gains of 13-15 per cent.

Now that the RBI has actively begun to reduce rates, it won’t take long for the bond markets to quickly factor in further rate cuts before they actually materialise. This is especially true because foreign institutional investors are today large participants in the Indian bond and G-Sec markets (this was not the case even five years ago). The commencement of the rate-cutting cycle in India (which creates opportunities for quick capital gains on bonds and G-Secs) is not likely to go unnoticed by such investors.

So, if you’re a passive debt investor, the first and most obvious thing to do is to lock into three-to-five-year deposits offered by banks and highly rated companies.

Slow credit offtake and margin pressures suggest that banks, NBFCs and companies may trim their deposit rates faster than their lending rates. Many of them have already begun doing so, three to four months ago.

Here, it is best not to worry about a few basis points and to lock into good quality deposits as quickly as you can. The 9-10 per cent rates they offer today are lower than a few months ago, but seeing how low interest rates can go in a falling rate cycle, these are good enough to see you through the next three-five years.

Given reinvestment risk, it is also best to go for the longest possible tenure on these deposits. If you’re an active investor who would like to surf the falling rate cycle, the best way would be to buy gilt and income funds which hold long-duration portfolios as they will gain the most from rallying bonds.

Such funds already sport one-year returns of 15-17 per cent. They carry interest rate risk; your investment can take a significant knock if the RBI decides to pause. But if you’re game for this, given the significant downside left in interest rates from the current levels, you should act fast and make sure you buy long-duration debt funds.

Given the market’s habit of pre-empting the RBI action, it may soon be too late to jump on to this bandwagon.

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