Target maturity funds can help you avoid losses amid rising interest rates

Stick to shorter tenure fixed deposits now to benefit from higher rates later

The benchmark 10-year government security (G-Sec) yield rose sharply after the Budget was announced last week. It touched a peak of 6.95 per cent before retreating slightly to 6.88 per cent. With the low interest-rate environment prevailing since the onset of the pandemic likely to change, investors and borrowers need to be prepared to deal with the emerging scenario.  

Higher govt borrowing driving up yield

The key factor that drove the 10-year G-Sec yield up last week was the Budget ann­ouncement on government borrowings for financial year 2022-23 (FY23). “The market was expecting gross borrowing to be in the range of Rs 13-13.5 trillion but the budget revealed it would be Rs 14.9 trillion,” says Indranil Pan, chief economist, YES Bank.

Bond dealers were also expecting clarity on tax issues, which would have facilitated Indian bonds’ inclusion in global indexes. “The government did not announce the tax changes that could have resulted in inclusion, and thereby fund inflows from abroad into the Indian bond market,” says Arvind Chari, chief investment officer, Quantum Advisors.

The RBI is now on course to normalise monetary policy (reduce liquidity and raise policy rates). “That puts a question mark on the extent to which it can offer bond buying support,” says Chari. Pan adds that the demand-supply equation for government bonds has got skewed towards higher supply.

Crude oil crossing $90 a barrel is another worry for the bond market. “There are fears crude oil prices could rise much higher. And even if they soften, they may not soften much,” says Chari. Higher crude prices could force the government to reduce the excise duty. This could put pressure on its revenues and result in a higher fiscal deficit.

Globally, too, central banks are hiking rates. The market expects the US Federal Reserve to raise rates as many as seven or eight times.  

According to Pan, “With most of the government borrowing likely to happen in the first half of the year, the 10-year G-Sec could rise to 7.25-7.30 per cent level in the first half.” He expects this rate to soften in the second half as the US Fed’s rate hikes lead to inflation and oil prices cooling off. He expects this benchmark to move in the 6.75-7.25 per cent range in FY23.  

Will the RBI hikes rates?

The RBI is expected to first change its stance from accommodative to neutral and then move to repo rate as its policy rate. After its February 7-9 meeting, the monetary policy committee may hike the reverse repo rate to 3.75 per cent. Experts expect rate hikes to begin from April.

Pan expects one-two rate hikes in FY23. Chari expects four rate hikes of 25 basis points each in this period.

Stick to short-term FDs  

The increase in bank deposit and lending rates may be more muted than the rise in G-Sec yields. “The RBI has maintained adequate liquidity. And while credit flows have moved up compared to last year, deposit accretion remains higher. Bank deposit and lending rates may not move up much unless credit demand rises sharply,” says Pan. Deposit rates have inched up by 5-15 basis points only so far.

Fixed deposit (FD) investors should avoid locking in money for longer tenures. “It is difficult to predict the peak FD rates will touch in this cycle. Stick to FDs of one-two-year tenure. This will allow you to re-invest at higher levels if interest rates continue to rise for a longer period,” says Gaurav Aggarwal, senior director, Paisabazaar.com.

You could also ladder your FDs to avoid guesswork on FD rates. “If you have Rs 10 lakh, spread it equally across one- to five-year tenures,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor. Laddering will allow you to average out returns.

Avoid excessive dependence on FDs. “For an investment to be truly rewarding, its post-tax return must be at least a few percentage points above inflation. Assuming an average inflation rate of 6.5 per cent, your investment should provide returns in the range of at least 7.5-8 per cent after tax. FDs have a long way to go before they reach those levels,” says Adhil Shetty, chief executive officer, BankBazaar.com.

Avoid MTM losses with liquid funds

Investors with large sums parked in savings accounts should move them to liquid funds. “Liquid funds carry very little mark-to-market (MTM) risk. Their portfolios will keep getting repriced at a faster pace as interest rates move up,” says Chari.

Medium- and longer-duration debt funds are likely to be volatile and should be avoided. Take exposure to these funds once the 10-year G-Sec crosses the 7.5 per cent mark. Even shorter-duration funds (with portfolio duration of up to one year) could see some MTM losses amid rising rates.

Target-maturity funds are another good option in a rising rate scenario. Choose a fund whose tenure matches your investment horizon. “If you hold these funds until maturity, you will get a return close to the yield to maturity minus the expense ratio,” says Raghaw.

Don't over-leverage

Those who plan to take on a large liability like a home loan must avoid over-leveraging. The sum total of EMIs to take-home salary should not exceed 50 per cent.

Borrowers can take a few steps to offset the impact of rising rates. “New lenders should compare the loan rates of as many lenders as possible to get the best rate. Existing borrowers should exercise the option of home loan balance transfer if it results in significant savings,” says Aggarwal. Raghaw suggests prepaying your home loan periodically.  

Key points to remember

• Economists currently expect the 10-year G-Sec to rise up to 7.25 per cent in the first half of FY 2022-23 and then cool off in the second half  
• Expectations regarding rate hikes by the RBI range from two-four during the next financial year·       Shift money from savings account to liquid funds as the benefits of higher interest rates will get transmitted to you faster there
• Fixed deposit investors should avoid locking in rates for the long term to get the benefit of higher rates later
• Alternatively, they may follow the laddering strategy
• Debt fund investors should opt for target maturity funds and hold them until maturity to avoid mark-to-market risk in a rising rate scenario