How to Optimise Portfolio Allocation at the time of Rising Interest Rate?

Monday, September 17, 2018
By Rahul Agarwal

Rahul Agarwal, Director Wealth Discovery, EZ Wealth

Before deciding on finding ways to optimize one’s portfolio allocation in an increasing interest rate regime it is important to understand that how do rising interest rates affect one’s portfolio. Basically, when interest rates go up the cost of borrowing goes up for everyone, including corporates, individuals and Government bodies. For companies due to higher interest rates their margins are affected as the overall cost of borrowing goes up, this results in lower earnings hence it leads to depressed stock prices. For investors who are already invested in bonds their existing bond portfolios will see a decline as bond prices adjust downwards to accommodate higher yields, for new bond buyers it will be a good opportunity to lock in higher coupon payments.

Historically, rising interest rates have a negative correlation with the stock market returns, although this relationship does not always hold true for e.g. in the current situation both stock markets and interest rates are going up at the same time. There is a general euphoria about investment in the stock markets as the returns over the last couple of years have outperformed fixed income securities and bonds by a huge margin. The following table summarizes the impact of interest rate hikes on various asset classes.

This year Reserve Bank of India (RBI) has consecutively increased its key policy rate two times, repo rate was increased by 25 bps to 6.5 percent on August 1st 2018, in line with market expectations and following a similar hike in the previous meeting. The rate hike was consistent with a neutral monetary policy stance and is in line with achieving the inflation target of 4 percent +/- 2% while supporting growth. Going forward it is reasonable to assume that the possibility of rate hikes in the future is a real one if the inflation remains a concern, the Indian Rupee continues to be weak and the crude prices remain elevated.

An optimized portfolio has to be diversified portfolio and should have a healthy mix of equity and debt based on one’s risk tolerance and financial goals. Although interest rates can go up, we do not expect a significant increase in the interest rates and therefore we do not expect the Equity market returns to underperform the returns from the debt funds. For investors who do have higher portion of equity in their portfolios we would advice them to stay invested in the equities and for the debt portion of the portfolio investors should exit the bonds with longer maturities and switch to short term debt funds as a protection against interest rate risk.

Portfolio optimization in the environment of higher interest rates is a major concern for individuals who are risk averse and have significant exposure to debt instruments. In such situations the optimal strategy is to protect one’s portfolio from interest rate risk and that can be achieved by reducing the duration of their debt portfolio by exiting higher duration debt funds and investing into shorter duration debt instruments. One can maximize their portfolio returns by opting for higher rated corporate debt, increase their exposure in fixed income assets such as Bank FD’s, small savings products such as PPF and non convertible debentures.

To summarize, interest rate risk affects investors who have higher debt portion in their investment portfolios, as a strategy and based on one risk tolerance one should always opt for a diversified portfolio’s of debt instruments and should avoid over exposure to only one type of asset class.

Email this
COMMENTS
No Comments Posted
POST YOUR COMMENTS
Name:  
Email:    
Comments: