Making money from rate cuts

Interest rates i.e. the price of money is the key to economic growth because businesses run on the borrowed money. This borrowed money need not be only loans that companies take to launch their projects, products and run operations. The borrowed money can also be loans taken by a customer to purchase products like cars or homes through bank loans or electronics using credit cards. In plain economics the world of debt that we live in can be strongly impacted by minor changes in the interest rates.

So lower interest rates produce growth however because it makes money easily available, it causes price to rise i.e. inflation. The RBI thus has to maintain the balance of growth and inflation by managing interest rates. The damage caused by inflation in our country is drastic – it not only lowers the financial capability of individuals but given the majority of population is lower income group, the impact is widely spread out. Inflation harms our population immediately however growth benefits them in the medium to long term. Indian GDP growth has been declining for last few years and this has led to RBI starting the interest reduction cycle.
So from the investment point of view, how do these interest rates impact one’s investments? Well, although the impact can be felt across various asset classes, let’s focus on the impact of interest rates on mutual funds with majority allocations to fixed income & debt instruments.
The direction towards which interest rates move is the key to investing in debt mutual funds. Fixed income investors and fund managers tend to go for long term debt funds when interest rates begin to fall, and for short-term debt funds when interest rates are rising. Why is it so? Simple economics – prices rise when there is an increase in demand and fall when demand falls. The same holds true for bonds with long durations and interest rates. When interest rates rise, the price of bonds fall and it rises with a fall in interest rates. There is an inverse relationship between interest rates and bond prices.
Thus whenever interest rates are set to fall, it is recommended to buy funds such as income funds, gilt funds, and bond funds that hold papers of longer duration. However short term debt instruments are less sensitive to rate movements compared with the long term ones. So, when interest rates are on the rise, it makes sense to move to short term funds that invest in papers of shorter duration. A fund manager when expecting interest rates to rise would realise that the prices of bonds are set to fall because of higher supply. So he would sell off the long duration papers and moves into short duration papers.
Given that the monetary policy is shifting in favour of growth and inflation showing downward trend, there is a case for interest rates to go down even further, from the current levels. Also, since the monetary policy on January 29, 2013 yields have reduced a bit. This is a good opportunity for investors to gain exposure to long-term debt funds with minimum of one year horizon. But interest rates volatility would be inherent to such funds. Hence, those seeking to mitigate such volatility could consider fixed maturity plans of similar tenure.
Given the falling interest rate scenario, there are few other factors that matter before one makes his investment plan for debt funds. They are alternative investment options in the debt market and investment horizon. Investors who are confident of their ability to enter and exit at the right time from duration funds, can choose between short term bond funds and income funds, depending on their risk appetite. Investors who don’t want to time the market themselves should look at a product like the dynamic bond funds where the fund manager will add and reduce duration in the portfolio based on the views on interest rates at any point in time. From a tax efficiency perspective, a dynamic bond fund may be more suitable.
Investment horizon is another important factor for one’s investment plan. If one needs his money for his/her financial goals in the near term, then investing in long term funds would not be a good idea. Ultra-short term funds would be more suitable to him/her, where the average maturity of the underlying paper is up to 90 days. For those wanting to stay invested for a year or more, income funds or fixed maturity plans are better options. For financial goals that are 2 to 5 years away from today, long term bond funds would be a good investment avenue given the falling interest rate scenario. Also investors have to remember that short term gains in debt funds are taxed according to the applicable tax slab whereas long term gains are eligible for the inflation indexation benefit. The author is a member of The Financial Planners’ Guild, India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.