What to do when interest rates rise

High inflation is not news anymore. Petrol prices in Mumbai increased 23% to Rs. 68 a litre in the past year, one dozen eggs now cost Rs. 42, up from Rs. 34 a few months ago, the list can go on. An inflation of around 9% and policy rate (repo) at 7.5% means we are living in times of negative real interest rate—money is buying less and it’s time to maximize what it earns.

But it’s easier said than done. Equity markets are volatile and have fallen 7.77% year-to-date; gold prices declined 1.13% last month. But there’s still another opportunity. Rising inflation also means rising interest rates, making fixed-return instruments attractive. Your choice should depend on your investment horizon and the risk-return balance. Here’s what you can look for over various horizons.

Up to six months

Over such a short time period, the focus needs to be on liquidity. But that doesn’t mean you stick to your bank account giving 4%. High policy rates have impacted short-term rates the most. Liquid funds, which typically have average maturity up to three months, were offering close to 5% about six months ago; their returns are up at 8.5-9% per annum currently. The average maturity of a fund tells us the maturity profile of the securities that are part of the fund. For example, a fund with an average maturity of three months will mostly have securities that mature within the same time. Ensure your investment horizon matches with that of the fund.

Ultra short-term funds also serve liquidity requirements; you have the option to move money in and out without compromising on the returns. These are currently giving pre-tax returns of 8.5-9.5% per annum compared with 5.25% in December 2010. Some funds may have a load for exiting within 7-15 days, so check before investing. Ultra short-term funds have a significant tax advantage over liquid funds.

In both cases, go for the dividend reinvestment option that makes returns tax-free in your hands. However, there’s a dividend distribution tax (DDT) that gets deducted at source by the asset management company. In liquid funds, DDT for individuals is 25% and in ultra short-term funds 12.5%. This is subject to a 5% surcharge and 3% cess, bringing the effective tax rate to 27.037% for liquid funds and 13.519% for ultra short-term funds.

Six to 12 months

Here, you would typically want a combination of liquidity and returns.

Some short-term income funds come with slightly higher average maturity periods of three-six months or more, and give higher returns. Their current annualized returns are around 9-11% (however, this can change in a matter of weeks); in December 2010, the rate was around 5%. Here, returns track current yields on short-term securities, which depend on policy rates and the economic environment. These funds, typically, charge an exit load before three-six months. They are ideal if you can leave money invested for six-12 months. To tide over credit risk concerns, choose a fund that is mostly invested in AAA equivalent securities even if it’s giving lower returns than funds invested in low-rated securities. Portfolios published every month have information about the credit quality of holdings.

Says Mahendra Jajoo, chief investment officer (fixed income), Pramerica Asset Managers Pvt. Ltd, “High short-term rates are being reflected in returns of fixed maturity plans (FMPs) and short-term income funds. I continue to be optimistic on short-term rates, which I believe peaked in March. They will remain firm for the next few months as the Reserve Bank of India may hike policy rates by another 50-75 basis points this year.”

One to two years

Fixed deposits (FD) and FMPs are suitable for investors looking at this term. FDs are offering 8.5-9.5% over one-two years and some private sector banks are offering as high as 10% per annum. This has increased from around 7-7.5% last year. Company deposits offer a slightly higher return of 10-11%. A one-year FMP, too, is giving between 10-11% annualized returns, though FMPs will neither indicate nor assure any returns.

Says Suresh Sadagopan, a Mumbai-based financial planner, “One-year FMPs are very attractive with post-tax returns of 8.5% or so. There is a possibility of slightly higher returns if policy rates continue to be tightened, but waiting for that is not efficient as you lose out on interest in the meantime and the upside from here is not so significant.” For FMPs, the effective tax rate is 13.519%. FDs on the other hand are taxed at your marginal rate.

While bank FDs carry minimal risk, check the credit rating in case of company deposits and the portfolio of FMPs. Also remember that both FMPs and FDs are not liquid. Exit before the lock-in gets over will come at a cost.

Two to five years

If you can remain invested for the next few years, but don’t want to take any risk, bonds and non-convertible debentures would work for you.

Bond issues are available in the primary market if the company comes up with a public issue. A recent primary market public issue by Shriram Transport Finance Pvt. Ltd offered a maximum return of 11.6% to retail investors. Earlier this year, State Bank of India had a retail bond issue giving 9.75% per annum.

Bonds are liquid since they can be traded in the secondary market. Bond prices have an inverse relation with interest rates and rise when rates are on their way down. But typically trading volumes are low, which means there is high liquidity risk in case you want to exit before maturity. If you are a long-term investor, hold till maturity. Says Jajoo, “Negative real interest rates are currently fuelling inflation. There is high uncertainty about long-term rates and hence high risk. Investing in bond funds for capital gains from falling interest rates is an aggressive stance today.” The other option is three-five-year FDs, which are currently giving returns of 8.5-9.5% per annum, with private sector banks scoring better than government-owned sector banks. Company deposits, too, are available for three years, the returns are in the range of 8.5-11.5% per annum. Some finance companies offer 7-7.5% per annum.

When buying bonds or company deposits, look at the credit rating—a higher return is usually accompanied by higher credit risk or risk of default. Interest payout for both bonds and FDs are taxable at the marginal rate of tax.

Thanks to high policy rates, fixed-income investments across maturity periods are giving higher returns compared with last year. So make the most of it.

Source: http://www.livemint.com/2011/07/10214149/What-to-do-when-interest-rates.html