Interest Rate Changes and Their Effects on Investment Portfolios

If you want to learn how interest rate changes impact investment portfolios in the Indian stock market, you must understand the concepts discussed here.

The monetary policy of the country is governed by the Reserve Bank of India. RBI governs the interest rate and has a direct influence on the repo rate (the rate at which it lends to banks)and the reverse repo rates ( the rate at which it borrows from banks). This is done to maintain economic stability and control inflation.

Let's understand it’s working. In times of high inflation, RBI increases interest rates to reduce liquidity in the economy, and to reduce rising prices. However, when the economy is in a slowdown, interest rates will be reduced.

Changes in RBI's policies can have a ripple effect across fixed-income investments, bond prices, and the stock market. For investors, staying updated on monetary policy and investment decisions is crucial for effective interest rate risk management. It provides a clear roadmap for making informed decisions to navigate India's dynamic economic environment.

How Do Interest Rates Work?

Interest rates are one of the macro tools used by the RBI to control the supply of money in the economy. Higher interest rates make borrowing expensive and hence reduce the money flow in the economy which reduces the purchasing power and hence brings down the inflation.

However, if the interest rates are reduced the money flow increases in the economy, and then the purchasing power increases, which further increases the demand. Hence the economy rises and comes to the normal level.

How Do Changes In Interest Rates Impact The Broader Economy?

Interest rate changes have a strong effect on the economy and financial markets. Here’s how:

1. Consumer Spending and Business Investments: When the interest rates are higher, loans become more expensive, reducing consumer spending and corporate borrowing.
When the rates are lower the spending and investments increase as borrowing becomes cheaper.
 

2. Inflation Control: In times of inflation interest rates help to reduce inflation and in times of economic slowdown interest rate changes help to bring the economy back to normal. Inflation is reduced by increasing interest rates and vice versa

3. Currency Value: This might be a little tricky to understand but let's understand it with an example, If you were given a chance to lend your money who would you lend to? One paying higher interest or low interest? Obviously the higher interest.

Similarly, when interest rates are higher it attracts more foreign investments and the value of the currency ( the Indian Rupee) will increase. This will strengthen the currency in the world markets.

 

Effect Of The Interest Rate On The Stock Market

Now that you have understood the effect of interest rates on the economy and individuals let's understand the effect of interest rates on the stock market.
 

1. Valuation of Stocks

When the interest rates increase the cost of capital increases, this leads to a reduction in profits consequently lowering the stock valuations. However, the lower interest rates reduce the cost of borrowing. Businesses grow as the capital is available and hence the profits increase, often boasting the stock prices.
 

2. Sector-Specific Impact

 Interest rates will naturally have an effect on the banking sector, real estate, and infrastructure sectors. If the interest rates rise the banks will benefit and hence banking stocks will rise. In the case of real estate, the same can have a negative effect as the higher the interest rates higher the cost of borrowing. You will be able to see the effect easily on the stocks of infrastructure when the interest rates change.

Below is a table showing the interest changes and the effect on various companies in real estate and infrastructure sector.

3. Investment Shift

When the interest rates rise the behaviour of the investors changes as they shift capital. Investors often shift their capital from equity to fixed-income investment options like bonds, fd, etc. Investors choose to invest in fixed-income instruments because they carry less risk and are now giving more returns due to changes in interest rates.

However, when interest rates are lower the investors choose to invest in equity as the return is higher even though it comes with certain risks.

How To Manage Your Portfolio With Changing Interest Rates?

You need to adapt your investment portfolios to changes in interest rates to minimize risks and increase returns.  Be it dealing with fixed-income investments and interest rates or adjusting your equity portfolio to the changes, a well-planned approach is necessary. Here a some ways to do it.

1. Diversification Across Asset Classes

Interest rate changes affect each asset class differently we already understand it now. Let's see how to use asset diversification to make the best possible returns on your portfolio.
 

      > Bonds and Fixed-Income 

Generally, short-term bonds are less sensitive to rising interest rates than long-term bonds. During higher interest rates, shifting a portion of your portfolio to short-duration bonds can reduce exposure to the inverse relationship between bond prices and interest rates. In 2022, as RBI increased the repo rate, long-term bond funds underperformed, while liquid and ultra-short-term funds offered better stability.
 

      > Equities

Rate-sensitive sectors like banking and infrastructure perform differently during rate changes. For instance, banking stocks like ICICI Bank tend to benefit from rising rates due to improved net interest margins. If you allocate your funds to stocks that are favorable to the changes in the interest rates you will gain positive returns. However, don't invest in the stocks of the companies related to real estate during the time of interest rise.
 

2. Focus On Quality Stocks

Now think of a scenario when the interest rates rise, what will happen? Stock prices of the companies with more borrowing will drop. However, companies with less borrowed capital will rise or stay unaffected. Hence investing in companies with less debt will prove to be fruitful.

Hence if you invest in a fundamentally strong company with no debt will not be bearing the cost of the high interest rates. Investing in companies like Infosys and TCS which have very little debt can help you attain portfolio stability.

3. Use Floating-Rate and Inflation-Protected Investments

Floating-rate bonds adjust payouts based on the prevailing rates, making them attractive in a rising rate environment. Similarly, inflation-protected securities safeguard against eroding purchasing power during high inflation. Hence in a time of high rates, RBI’s floating Rate Savings Bonds saw increased demand because of an effective hedge for investors.

4. Monitor the Economic Cycle

Now that you have understood the effects of interest rates on the different sectors you should understand the effects of interest rates on the economy. During the rate cuts companies like Godrej Properties and infrastructure firms like L&T gain when the borrowing rates are reduced. Whereas when there is stable cash flow banking stocks offer better returns.
 

Conclusion

Interest rate changes have a direct impact on your portfolio if you font take the necessary action to hedge it against the risk. Hence make sure you are up to date with the recent changes and accordingly take your financial decisions. Effective portfolio management means that you must have a clear understanding of the stock market also. If you are struggling to find when to take entry in a stock and what should be the target then make sure you register for the free workshop to learn how to find the exact entry date, target, and exit date. Click here to register.