As economic growth falters and prices rise, inflation has become a major concern for policymakers around the world. The US Federal Reserve had to act after ignoring inflation for so long and dismissing it as a passing fad. In March 2022, the US central bank raised interest rates by 0.25 percent in an effort to rein in rising prices after a long period of interest rates near zero.
Indian interest rates rose by 40 basis points on May 4th, after a long period of low interest rates, the Reserve Bank of India (RBI) said. For investors, rising interest rates have both positive and negative consequences, as you'll learn in this blog.
An Ever-Rising Trifecta: Inflation, Rates of Interest, and Bond Yields
As a result of the Russian-Ukrainian conflict, commodity prices are showing no signs of easing and inflation remains high. Future inflation is expected to remain above the current target set by the RBI. As a result, interest rates have been raised by the central bank. As a result, investors in the bond market have become alarmed. In addition, bond yields surged above 7.4% on the day the RBI raised interest rates (May 4).
To begin, let's examine the connection between Bond Prices and Interest Rates.
There is a direct correlation between bond prices and interest rates. ' Basically, this means that when interest rates rise or are expected to rise, bond prices fall. Existing bonds lose value because newer issues with the same maturity date have higher interest rates. There is therefore a decrease in demand for currently issued bonds.
As a result, an increase in interest rates affects all forms of debt. However, the effect is more pronounced on longer-term papers than on shorter-term papers. This is due to the lower volatility of short-term debt papers compared to longer-term bonds. Since rising interest rates are more likely to affect short-term paper prices, debt mutual funds that invest in those tend to do better than those that invest in medium- to long-term paper..
Bond yields have risen from 6.8% to 7.2% in the last month.
Debt funds with medium and long-term maturities saw their returns fall from double digits in 2019 and 2020 to single digits in 2021, when 10-year benchmark yields rose from 5.8 percent to 6.5 percent in the calendar year.
Rising Bond Yields and Your Equity Investments:
For businesses, higher borrowing costs translate into higher costs of capital. Firms' bottom lines are directly affected by the rising cost of capital.
As a general measure of the cost of debt, the government's 10-year bond yield is commonly used as a proxy To put it another way, a rise in interest rates means a rise in capital costs, which lowers returns and makes equities less appealing.
Equity markets have fallen about 6% in the past few trading sessions as a rate rise is expected.
Even in the past, we've seen when the famous taper tantrum occurred; in August 2013, the yield on Indian government bonds reached a historic high of 9 percent. In just one month, the price rose by 22%. 9 percent stock market correction was caused by this.
What Can Investors Do As Interest Rates Continue to Rise?
A rise in interest rates has an effect on the equity and debt markets in equal measure. Trying to predict where the stock market will go next is a bad idea when investing in equity. Diversification and asset allocation are essential. Continue with the SIPs you've been working on.
Debt funds that invest in shorter-term maturity bond papers are a better choice when it comes to debt investments. When interest rates rise, short-term debt funds perform better than long-term debt funds. This is due to the fact that shorter-maturity papers are less affected by interest rate increases.
When it comes to short-term investments, liquid or low-duration funds can be a good option. The time frame for investing in ultra-short-term mutual funds is 6-12 months. In money market funds, you can put your money to work for you for a year or two. There are several short-term debt funds and corporate bond funds available for investors with a time horizon of two years or more.
It is important to keep in mind that the fund is taking a credit risk. Don't cut corners when it comes to the quality of debt papers.