RBI Repo Rate Raised By 25 Bps: What It Means For NPS Subscribers

The Reserve Bank of India (RBI) raised the repo rate by 25 basis points (bps) after around three-and-a-half years, bringing it to 5.50 per cent. The last rate hike was made in February 2023. This rate hike will impact borrowers negatively, but bond investors are set to benefit from it.

Apurv Gupta, founder & CEO, Otto Money, a wealth management platform, says, “The repo rate is the main lever for interest rates in the economy. When the RBI raises it, interest on loans and deposits goes up. Though bond yields increase, existing bond prices fall. All assets, such as equities, gold, and real estate usually move in the opposite direction. When rates rise, these asset classes tend to come under pressure, as borrowing becomes costlier and fixed-income options look more attractive. We are seeing a monetary tightening cycle, and the MPC has changed its stance. Short-term bonds are the safer bet than playing duration.”

The rate hike means the bond yield will increase, and equity could move in the opposite direction. 

For National Pension System (NPS) subscribers whose NPS portfolio alone comprises equity and debt (government securities and corporate bonds), what does this rate hike mean? Should they need to review and rebalance their asset allocation now?

There are two investment choices for NPS subscribers: Auto Choice and Active Choice.

NPS subscribers who have opted for Auto Choice need not bother about asset allocation because the pension fund makes the changes depending on the market conditions, changing interest rates, etc. However, subscribers who have opted for Active Choice need to understand the impact of a repo rate hike on their portfolio. 

Impact On Equity Investment

Active Choice permits subscribers to invest up to 75 per cent to equity. However, the direct impact of a rate change on equity remains limited because the return on it depends on companies’ earnings growth, valuations, and risk appetite, among several other factors. The rate hike can indirectly increase corporate borrowing costs and reduce demand in loan-driven sectors, such as housing and auto. It can trigger short-term volatility.

However, NPS is a long-term product with a 2-3 decades or longer horizon. Considering its long-term horizon, a single 25 bps hike is just a small blip, not necessarily requiring a cut in equity exposure.

Impact On Interest Income Instruments

On the other hand, the rate change has a direct impact on the fixed income instruments. Existing corporate bonds (C) could face a short-term net asset value (NAV) dip because when yields rise, existing bond prices fall. But if a fresh investment is made in a bond at a higher yield, it can improve future returns.

Government Securities (G-secs) are highly rate sensitive. While rising yields put the NAV of the existing long-term holdings in G-secs under pressure in the short term, fresh investment in them earns higher yields.

Simply put, the interest rate hike hurts the existing NAVs in the C or G-secs, but improves yield on new contributions in the same (C and G-secs) assets.

Should NPS Subscribers Rebalance Their Portfolio?

Vivek Iyer, partner and financial services risk advisory leader, Grant Thornton Bharat says that the repo rate increase of 25 basis points needs to be understood in conjunction with the fact that the RBI is going for calibrated tightening.

“It means interest rates are going to increase. Hence, it makes sense to reduce the long-duration bonds in the portfolio to short-duration bonds to minimise the portfolio risk. The active buyers would need to make this change. No change needed for the auto choice subscribers as rebalancing is built in that framework,” he says.

For NPS subscribers under Active Choice, keeping track of their portfolio is essential because when yields rise and equity values decline, the asset allocation ratio changes in the portfolio.

But not all changes are worth a rebalancing in an NPS portfolio.

Manish P. Hingar, chartered accountant, founder and chief executive officer, Fintoo, says, “A quarter-point (25 bps hike) move is too small to justify a big switch, and NPS is a long-term product that sees many rate cycles over its life. A better trigger is drift: rebalance only if your equity-debt mix has moved more than 5 percentage points from your target. You get a limited number of allocation changes each year, so don't burn one on a single rate decision.”

He adds, “At 40, with 20 years left, an Active Choice split could be 70 per cent equity, 20 per cent corporate bonds and 10 per cent government bonds. At 50, with 10 years left, it could be 50 per cent equity, 30 per cent corporate bonds and 20 per cent government bonds, with equity trimmed by about 2-3 percentage points a year.”

So, to rebalance the target allocation, subscribers who are far away from retirement may consider fresh contributions to equity, provided that the rate hike has changed asset allocation by more than 5 per cent. Those near retirement may continue or raise exposure to C and G-secs to benefit from the higher yields.