Impact of Inflation on fixed income investments

Understanding Inflation is one important aspect of prudent investment strategy. The inflation numbers have ripple effect on every aspect of the economy ranging from consumer spending to investment cycle to government policies. Prevailing inflation rates have a major say in deciding the interest rate decision making process of policy makers.

Generally, when a country is operating in a low interest rate regime, borrowers can borrow money at a lower interest rate. This aids in increased purchased power of the consumers. The demand for the goods increase and subsequently sensing a higher demand, the prices will also raise. This condition drives the inflation rates higher. When the inflation rates raise more than the optimal levels, the Reserve Bank steps into increase interest rate to control inflation rate.

Maintaining an optimal inflation rate is the primary task of Monetary Policy decision makers of any nation. An optimal inflation rate ensures a healthy economy. More often than not, the policy makers tend to spur growth in a stalled economy by slashing the interest rates, there by increasing the money available in the markets. However, in order to implement such rate cuts the inflation rate should be at an optimal level. So, it becomes a the prime responsibility of Reserve Bank to monitor Wholesale Price Index (WPI) and Consumer Price Index (CPI) to ensure that economy is balance.

Inflation has been one of the concerning factors in growth story of India over the last couple of years. Though the growth rates are not satisfactory, India had to maintain high interest rate regime owing to high inflation rates. However, the Inflation numbers eased in the month of April. WPI is recorded at 4.89% compared to its above 7% levels during the last fiscal year. The low inflation rates have provided breathing space for RBI to enforce further rate cuts in the current fiscal year.

The price of fixed income securities is inversely proportional to the interest rate. Lower Interest rates will aid in fall of yields of fixed income securities. A fall in yields will push the bond prices higher and hence the NAVs of debt funds. When the interest rates increase the price of the fixed income security decreases and similarly when the interest rates are slashed, the price of the fixed income security increases. The change in value of the investment based on the changes in the interest rates is generally referred as interest rate risk.

The interest rate risk is directly proportional to the duration of the fixed income security. In the scenario of falling interest rates, it is an astute decision to invest in fixed income securities. Falling interest rates are a good sign, especially for long-term government securities and income funds. Debt oriented funds with an investment horizon ranging from short to medium are also expected to give good returns in the falling interest rates regime. When it comes to fixed maturity products, investing at the start of rate – cut cycle is a good option. When the interest rates fall, the still pay the agreed interest rate which is higher before the rate cuts.

With the WPI and CPI showing signs of easing inflation, there is a room for further rate cut during the current fiscal year. This would help the fixed income securities perform well in the current fiscal year.

Authored by ArthaYantra.com, an integrated online personal finance company.