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Last Updated: January 27, 2006 13:17 IST
The Reserve Bank of India [Get Quote] took most experts by surprise by raising short-term interest rates. It hiked the reverse repo rate to 5.50% (from 5.25%). The RBI borrows from the banks at the reverse repo rate. It also hiked the rate at which it lends to the banks, the repo rate, to 6.50% (from 6.25%).
Contrary to popular perception, Personalfn is of the view that interest rates are likely to go up even further. The reasons are not hard to decipher -- demand for capital (as companies grow existing operations and set up new capacities) is showing no signs of receding.
If there is no slowdown in the demand for capital, the RBI is likely to step in at some stage; especially in the current environment where crude prices could fuel inflation. Investors will agree that none of these factors are conducive to a lower interest rate environment, which makes us believe that rates look likely to head only in one direction -- up.
1. Debt Funds/Fixed Deposits
Given the tilt towards rising rates, we are of the view that investors must adopt a cautious approach with regards to their debt investments. The best way to do that is to invest in short term debt funds/short term floating rate funds. Likewise, short-term FDs are a better option for those who prefer fixed deposits.
2. Equities
Companies generally rely on debt to meet their working capital and business expansion needs. When interest rates rise, the cost of this debt goes up. The rise in borrowing cost has an adverse impact on the profitability of these companies.
Lower earnings, all else remaining the same, will lead to lower stock prices.
A negative sentiment of the stock market often translates into a positive sentiment for the debt market, because the risk-return scale tilts in favour of the latter. So money could well shift to debt.
Its also no secret that rising rates is upsetting for investors who borrow at market-linked rates to invest in the stock market. The higher borrowing cost makes them want a higher return from their investment; thereby implying that they are looking at a lower 'entry' cost (i.e. lower cost of acquisition).
3. Home Loans
The good news for individuals is that a rise in interest rates does not automatically translate into a corresponding rise in home loan rates. However, given that interest rates could persist at higher levels for some time, home loan companies are likely to increase their rates at some stage (as some already have).
This is our recommendation for individuals who have either taken or are looking to take a home loan:
Investors with a low risk appetite should opt for a 'pure' fixed rate loan. In this case, the rate on the home loan is fixed throughout the tenure of the loan.
The only risk you run over here is that over a 15-20 year tenure, interest rates could decline. By opting for the 'pure' fixed rate loan, you will be unable to benefit from the same.
This is where floating rate home loans come in. The rate on such loans is adjusted periodically to account for a change in the interest rate scenario.
From the individual's perspective, this is a risky proposition because over a 15-20 year period, he could see this rate change often thereby disturbing his EMI (equated monthly installment) or tenure schedule. Most individuals prefer some degree of stability in their EMI/tenure liability, so fluctuations in the EMI/tenure schedule may prove to be upsetting
This is where fixed home loans, with a periodic revision clause (usually 3/5 years), come in the picture. The rate on these loans is fixed to begin with, but is revised at periodic intervals (3/5 years).
This is the best option in our view, because it allows investors to fix their home loan liability and also benefit from a downturn in interest rates in the future.
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