Investors and loan seekers have been witnessing a dramatic change in the Indian interest rate environment over the last few years. Home buyers today can get a loan at about 9% pa as against probably 15% pa four years back. Investors now expect to earn average returns of 8% pa as compared to 12% pa then. This structural change has had a significant, though mixed, impact on most of us.

However, we are not getting into the impact of this change on one's balance sheet. What we are going to tackle here is how investors and loan seekers must place themselves so that they can make the most of the emerging scenario.

What is the emerging scenario going to look like?
The Governor of the Reserve Bank of India (RBI) has said that given the normal conditions and overall stability, in view of the structural constraints, it is likely that the present nominal and real interest rates are now relatively low and may not have significant potential for further sizeable downward movement in India. (Statement from the press release of the Reserve Bank of India on the Monetary and Credit Policy for 2003 - 04)

In simpler terms this means that there is only a little chance that interest rates will move down significantly from their present levels.

Not surprisingly post the monetary policy announcement, debt markets took a bit of a beating.

Another factor that is likely to impact the interest rate environment going forward is recovery that is underway in the domestic economy. It is anticipated that a step up in economic activity, coupled with the huge government borrowing program, which shows no sign of abating, could at some point in time exert upward pressure on interest rates. Though not many expect interest rates to rise significantly, but this could create volatility in the debt markets.

How does this impact you?

If you are an investor¦
In the last couple of years, investors in debt mutual funds raked in large returns. Much of these returns were accounted for by capital gains i.e. as interest rates in the market fell, the value of existing debt securities increased. The interest component accounted for a small percent of overall returns. This scenario is likely to reverse in the coming years.

Leading income funds

Income (Long Term)  Funds	NAV (Rs)	NAV DATE	1-Mth	6-Mth	1-Yr	3-Yr	5-Yr	Incep.
HDFC INCOME G	14.7	1 May	1.8%	7.2%	14.4%	-	-	15.3%
SUNDARAM BOND A	20.1	2 May	1.8%	6.9%	14.3%	13.5%	14.1%	13.8%
TEMPLETON INC. BLD ACC G	21.8	2 May	2.1%	6.8%	14.1%	14.3%	14.1%	14.2%
BIRLA INC B	26.2	2 May	1.8%	6.4%	13.6%	13.6%	13.4%	14.6%
ZURICH I HIGH INT G	21.5	2 May	1.7%	6.0%	13.5%	13.9%	13.1%	13.4%
JM INCOME G	24.7	2 May	1.6%	6.1%	13.2%	14.7%	14.6%	12.2%

(Returns over 1-Yr are annualised)

Debt funds will now generate much, or rather most, of their returns from the interest earned on the debt securities they hold. Only a small portion of the returns will now be generated by trading (i.e. capital gains). The overall returns will be much lower than has been the case in the past.

So what should you do now¦

Given the fact that returns from debt schemes will be much lower going forward, investors will need to review their portfolios to ensure that in the new environment their objectives are being met. If yes, then probably there is not much to do except for maybe taking care of the volatility issue (dealt with later).

But if you are not going to be generating the kind of income you have been expecting to, you will need to rebalance your portfolio in favour of maybe the slightly more risky schemes  like the high interest rate funds which invest in the likes of AA quality paper (second highest level of safety), which offer higher returns and also the possibility of capital gains (if and when they are upgraded to AAA quality).

If you are already invested in debt funds (income, bond and gilt) and are likely to stay invested for a minimum of one year, there is no need for any change due to concerns pertaining to volatility.

However, for investors who are looking at minimising the possibility of erosion in capital even in the near term, there are the floating rate schemes which aim at generating returns in line with the interest rates in the market. Such schemes fulfill the role as a stabilising force in a portfolio in times of volatility.

Floating Rate Funds will provide much-needed stability

Floating Rate Funds	NAV (Rs)	NAV DATE	1-Wk	1-Mth	6-Mth	1-Yr	Incep.
GRINDLAYS FLOATING G	10.1	May 2	0.1%	0.4%	-	-	1.1%
HDFC FLOATING LTP G	10.2	May 1	0.1%	0.4%	-	-	1.4%
TEMPLETON FLOAT LTP G	10.9	May 2	0.1%	0.6%	3.1%	7.2%	7.2%

(Returns over 1-Yr are annualised)

As far as investors in government savings schemes are concerned, there is unlikely to be any change in the returns offered by such schemes. Only the EPF may see a rate cut. Going forward however, probably post the general elections, most government savings schemes are likely to see substantial cuts in the returns offered.

• Unsustainability of Govt. Saving Schemes

• Nilesh Shah, Chief Investment Office, Franklin Templeton Investments on the Monetary Policy

  If you are a loan seeker¦
  Interest rates on home loans have been declining mainly due to the cost of money having come down and the increasing competition in the sector. While there is doubt that there is any significant downside in interest rates from here onwards, few expect the same to rise.

  So what should you do now¦

  Given that this is a long term liability, loan seekers probably are still better off with floating rate loans. This is because expectations, even in the near term, are of volatility and not those of rising interest rates. And over the long term, given that the structural constraints would probably have been dealt with, interest rates could probably inch lower. On the other hand if one were to go in for a fixed rate loan, with the expectation of switching to a floating rate loan if interest rates were to decline, there would be significant costs that the home loan company would levy (as high as 2% of the outstanding loan).

  However, if you do not have an appetite for risk, you are better off with a fixed rate loan.

  The statement by the Governor of the Reserve Bank of India has put to rest the speculation among retail investors and loan seekers about the direction of interest rates going forward. Investors and loan seekers must now align their assets and liabilities in such a manner that they continue to move towards achieving their long term objectives.

   

  PersonalFN provides research recommendations to its premium research subscribers and financial planning clients. To know the recommendation on this investment, become a subscriber or client today. Click here to know about our research services. or Click here to know about our financial planning services. Or, simply write to info@personalfn.com. You can also call us at +91 22 6136 1200.

Add Comments