How to rebalance your portfolio when interest rates are rising?

Retail inflation is soaring in India because of rising international crude oil prices. The Russia-Ukraine crisis and the pandemic have led to surging inflation worldwide. Moreover, major central banks in developed countries are hiking interest rates to bring inflation under control.

RBI has hiked the repo rate by 40 basis points in May, and more rate hikes will follow. It is the rate at which commercial banks borrow money from the RBI by pledging government bonds as collateral. How do you rebalance your portfolio when interest rates are rising?

What happens when RBI hikes the repo rate?

A repo rate hike makes investments in specific fixed income instruments more attractive. However, it’s bad news for borrowers as car loans, personal loans, and home loan rates go up. For instance, ICICI Bank, Bandhan Bank, Kotak Mahindra Bank, Bank of Baroda, and others have hiked interest rates offered on their Fixed Deposits. 

However, SBI, HDFC Bank, ICICI Bank, PNB and others have hiked their Marginal Cost of Lending Rate (MCLR). It is the minimum rate at which banks are allowed to lend. If banks increase MCLR, your car, personal, and home loan EMIs will increase. 

The RBI repo rate hike impacts the stock market. For instance, companies cut back on spending for expansion, leading to a dip in growth and profitability. A repo rate hike affects the shares of rate-sensitive sectors such as banking and NBFCs, automobiles, infrastructure, and housing. 

How do you rebalance your portfolio when interest rates are rising?

RBI repo rate hike impacts your equity investments. For instance, mid-cap and small-cap funds could crash as medium and small-sized companies are affected by higher interest rates in the economy. 

Many medium and small-sized firms have massive debt on their balance sheets and could struggle with higher interest payments on loans. However, larger companies with low debt may do well in such a scenario. 

It helps to focus on large-cap funds that invest predominantly in large-cap stocks to strengthen your portfolio when interest rates rise. However, if you have invested in mid-cap and small-cap funds to attain financial goals based on risk tolerance, you must stay with your investments. 

Rising interest rates allow you to diversify your portfolio towards fixed-income investments. For example, many banks have hiked fixed deposit rates in a rising interest rate scenario. Investors can invest in debt funds with a portfolio duration of up to two years. 

One can look at ultra-short duration funds, low duration funds and short duration funds which do well when interest rates rise. However, it’s best to avoid long duration funds that invest in long term fixed income securities and gilt funds that focus on government securities. These funds are vulnerable to interest rate fluctuations in the economy. 

Financial experts recommend having around 5%-10% of gold holdings in your portfolio. Investors can look at Gold Exchange Traded Funds (ETFs) and gold funds to get the requisite portfolio holdings rather than physical gold. Gold ETFs are pooled investments that track domestic gold prices and are listed on stock exchanges similarly to shares. Gold Funds are Fund of Funds schemes that invest predominantly in Gold ETF units run by AMCs. In a nutshell, focus on debt funds of a shorter portfolio duration to rebalance when interest rates rise in the economy. 

For any clarifications/feedback on the topic, please contact the writer at cleyon.dsouza@cleartax.in