Tuesday, December 21

Investing in High Interest Rate Environment

India is in a rising interest rate environment. We have already seen the RBI raising interest rates five times since March 2010. Last week, in its policy review, the central bank left rates unchanged, merely reducing the SLR to 24% from 25%. However, this is certainly not the end of the story. With the inflation showing no signs of easing in the medium term, raising interest rates is one of the most important tools in the hands of the government/central bank.

Rising interest rates are generally not taken well by the investors at large. Firstly because it directly hurts the pockets of the individuals. The interest rates are increased to suck money out of the system and to curb the inflation. As rates increase, banks pass on the increase in rates to its customers and consequently home loans become more expensive. People having loans have less disposable income as their monthly payments increase.

Let's see how this impacts the businesses. Companies need funds to operate and as Capital Structure Theories tell us, they should maintain a balance between debt and equity. As interest rates increase, the debt becomes expensive and companies incur more interest expense. In a competitive market, generally it is difficult to pass on the same to the customers. Consequently, the owners (that is, the shareholders) take the hit in the form of lower profits. Needless to mention that a company reporting lower profits become less attractive for investors and thus the stock prices fall.

Higher interest rates often leads to investors switching from equities to fixed income securities (e.g. bonds) as they now offer higher returns to investors.

What should an investor do in a rising interest rate environment?
There are some sectors that more sensitive to interest rates than others. Sectors such as Banks, Auto, Real Estate are more sentive to interest rate changes than sectors such as Pharmaceuticals, FMCG and Capital Goods. That is not say that these are 'not' affected by interest rate changes, but just to say that are "less" affected as compared to more sensitive ones.

Further, investors should grill down to companies that do not have a high amount of debt in their books. A company which is more equity-financed would be less affected by interest rate changes than the one that has a high amount of debt on its books.

It's just about how the investor diversifies his/her portfolio that can hedge him/her against adverse movement in interest rates.

Happy Investing !!

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