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What to do when interest rates rise

The interest rate cycle is nearing its peak. Here's how you should break up the debt part of your portfolio among various products.

business Updated: Jul 16, 2011 02:10 IST
Lisa Pallavi Barbora
Lisa Pallavi Barbora
Hindustan Times

High inflation is not news anymore. An inflation of around 9.0% 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 maximise what it earns.

But it's easier said than done. Equity markets are volatile and have fallen 7.8% year-to-date; gold prices declined 1.1% 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 at over various horizons.

Up to six months
Here, 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. 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 5.3% in December 2010. Some funds may have a load for exiting within 7-15 days, so check before investing.

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 25.0% and in ultra short-term funds 12.5%. This is subject to a 5.0% surcharge and 3.0% cess, bringing the effective tax rate to 27.0% for liquid funds and 13.5% 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 annualised returns are around 9-11% (however, this can change in a matter of weeks); in December 2010, the rate was around 5.0%. 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. 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.

One to two years
Fixed deposits (FD) and FMPs are suitable for this term. FDs are offering 8.5-9.5% over one-two years and some private sector banks are offering as high as 10.0% per annum. Company deposits offer a slightly higher return of 10-11%. A one-year FMP, too, is giving between 10-11% annualised returns, though FMPs will neither indicate nor assure returns.

For FMPs, the effective tax rate is 13.5%. 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 offered a maximum return of 11.6% to retail investors. Earlier this year, State Bank of India had a retail bond issue giving 9.8% 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.

The other option is three-five-year FDs, which are currently giving returns of 8.5-9.5% per annum. Company deposits, too, are available for three years; their returns are in the range of 8.5-11.5% per annum. Some finance companies offer 7-7.5% per annum.

However, when buying bonds or company deposits, look at the credit rating.

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.

First Published: Jul 15, 2011 23:20 IST