Investing In Era Of Low Interest Rates

The Reserve Bank of India (RBI) in June lowered its key-lending rate for commercial banks to 5.75 per cent, the lowest in the last nine years. This was the third such cut this year in as many monetary policy committee meetings, and more cuts are likely to happen as the central bank also changed the monetary policy stance from neutral to accommodative. What this means is that interest rates may fall further in the coming months.

Meanwhile, the Central Government also lowered the interest rates on small savings schemes – including the Senior Citizen Savings Scheme, National Savings Certificate Scheme and Public Provident Fund (PPF) – by 10 basis points. While the interest rate for the five-year Senior Citizen Savings Scheme was lowered from 8.7 per cent to 8.6 per cent, interest rate on PPF deposits and five-year National Savings Certificate came down to 7.9 per cent from eight per cent earlier. Moreover, media reports as well as financial experts have predicted more cuts in coming months to bring these interest rates in line with government bond yields, which are falling as well.

Amit Gupta, CEO and Co-founder, TradingBells, felt that the recent fall in bond yields is indicating that we can expect a series of rate cuts this year by the RBI. Some analysts are expecting upto100 basis points rate cut this year due to dovish commentary by US Fed and other global central banks controlled fiscal deficit, the economic slowdown and a fall  in inflation.

In such a scenario, what should investors do? Experts are mostly divided on whether they should rethink their investment strategy in this era of low interest rates or should they stick to their current goal-based investment plans. Most of them feel that risky assets like equities prepare for a good performance during such low interest rate conditions. Thereby making valuations attractive and earnings growth possible, but it is safer to follow one’s asset allocation dictated by one’s risk profile and avoid tinkering with investments.

Rajiv Singh, CEO - Stock Broking, Karvy, said that India was for long the exception with high interest rates in the early part of the decade as low interest rates had been a feature around the world since the days of the global financial crisis. He added that interest rates have declined due to a fall in inflation. Underlining that the decline in both inflation and interest rates are structural in nature, Singh added that even as nominal interest rates are low, real interest rates in India are high, which are here to stay.

“While it is possible that inflation may rise from the current levels, it is unlikely to reach the high levels experienced earlier. There is one more factor driving interest rates lower. India has been opening up its bond market to foreign players, which is likely to increase foreign flows thus resulting in lower interest rates. However, one factor can drive rates higher. Bank credit has gone up, and growth rate in deposits have not moved up in sync, banks will need to increase deposit rates to attract deposits. Both of these factors should balance and rates should remain stable,” he said.

However, since investors recognise nominal rates that will drive asset allocation along with demographic changes, Singh stated.

“In the near term, central bank policy is also a driver. India currently has among the highest real interest rates in the world and gives room to the central bank to lower rates further to stimulate the economy,” he further added.

While a high inflation regime favours physical assets over financial assets, a high real rate regime makes financial savings more favourable thereby making equities and debt more attractive for savers, through products like deposits, insurance products, debentures, mutual funds and direct investment in equities. “It is important to remember that investors recognise nominal rates, and low deposit rates will drive retail investors to invest in more risky assets, which offer a higher rate of return,” Singh said.

Dr. Joseph Thomas, Head of Research, Emkay Wealth Management, said that in conditions of low-interest rates and smooth liquidity, equities prepare for a good performance as such salubrious conditions make valuations attractive and earnings growth possible. “Therefore, the low-interest rate is a positive signal for future equity performance  and returns.”

Gupta stated that even though some of the financial sector stocks might be trading at their historic lows, it would be wise to keep some interest-rate sensitive stocks in one’s portfolio amid a falling interest scenario. “Investors must be on the lookout for buying opportunities in good quality names especially those related to the housing theme such as HDFC, Asian paints, Pidilite, Kajaria and Oberoi Realty. Many auto stocks are also available at a reasonable valuation currently. Quality banks will continue to dominate in the financial sector in the coming months,” he said.

Thomas said that while investing in equities is a prudent and lucrative option for the long term investment portfolio with focus mainly on large caps, and then on mid caps to some extent, but he cautions that the most appropriate thing to do at this juncture is to follow the asset allocation dictated by one’s risk profile.

“The changes in the policy stance of RBI or other related developments do not warrant any change in the investment plan. The focus as far as debt goes should be into corporate debt funds. The two things one needs to keep in mind, invest in high-quality portfolios and stick to a maturity profile of two to three years. Those who have been following this in the last couple of years are well placed and effectively insulated from any major negative surprises while making reasonable returns,” he said.

Thomas added that the rate cut cycle may not be as deep as one would want it to be as interest rate cuts have been effected three times already by the RBI and we may see another two cuts at best.

Many experts are of the opinion that retail investors, as opposed to traders or institutional investors, should base their investment strategy on their goals and risk profile and that they should not tinker with their investments based on news.

Ankur Choudhary, Co-founder and CIO, Goalwise, stated that most of these events average out in the long run and in general one will get more benefit by increasing their investments than by anything else.

“There is always a trade-off between risk and returns. In search for higher returns, you may feel like allocating more to equity investments but that comes with a higher risk. Since markets are unpredictable and prone to down swings, you may end up losing your principal as well and may not have the risk appetite to wait for the turnaround. One should always invest according to one’s risk profile,” he explained.

But what happens when returns at the same risk level are diminished as is in the case when the lending rate is already at nearly nine-year low of 5.75 per cent which, while has had an easing effect on loan interest rates, but has also lowered interest rates on bank deposits. Add to that the reduced rates on small saving schemes.

With more cuts anticipated, this has left savers earning lower than they were used to while taking the same amount of risk. Romesh Tiwari, Head of Research, CapitalAim, said that even after this reduction of 0.1 per cent for small saving schemes these schemes remain attractive and only choice for risk averse or low risk profile investors.

“Interest rates in this segment have been disproportionately high from rest of the money market options mainly because no government wanted to infuriate the huge segment of small investors of these schemes. I think investors of small saving schemes should be prepared for more rate cuts in future as the government has started implementing its earlier declaration of linking rates of small savings schemes to government bond yields. If investors seek better returns on their funds, they must consider taking more risks and invest in other market linked schemes like mutual funds,” Tiwari  further added.

Summing up, Singh said that a combination of lower nominal rates and positive real interest rates, accompanied with demographic shifts are likely to lead to a lower allocation to physical assets like real estate and commodities like gold.

“For sure, demand for physical assets is likely to grow at a lower rate and will account for a lower proportion of household wealth. Financial assets, especially the  riskier ones are likely to witness a greater proportion of savings being allocated by households. This may be via financial products like mutual funds, insurance tools or even retirement products, or direct investments in equities,” he  further concluded.

vishav@outlookindia.com