Rising interest rates make it imperative that the fixed income investments or portfolio be reviewed for necessary changes and realignments. But one should not be under the impression that it is only fixed income investments that are sensitive to interest rate movements. In fact, all asset classes including even equity investments are equally affected by rate changes.
As interest rates rise, the value of fixed income portfolios gradually declines, and the highest decline is at the long end of the curve, or in long-term or long-dated instruments. The longer the duration of the portfolio the larger will be the loss of value, and therefore, the obvious action that is required to be taken is to reduce the duration of the portfolio. In other words, one needs to stay at the short end of the curve or invest in short maturity instruments so that the loss of value is minimized. This is one of the primary things to be actioned on portfolios against rising interest rates. However, at some point in time, even short-term portfolios or instruments may be adversely affected, though to a lesser extent. This too can be overcome by moving to the very short end like overnight funds or liquid funds, or one-month treasury bills, etc. This shift invariably anchors the portfolio to relatively lower yields for some time.
One way to keep the portfolio more stable is to move into floating rate instruments. These instruments come with a floor and a ceiling in the coupon, and the coupon gets reset at periodic intervals based on the movements in the benchmark. As the yield on the benchmark moves up or down, the coupon on the instrument that you hold will also be reset. Any rise in yields or a fall in yields would get reflected in the coupon. There are several instruments in the mutual fund space which help portfolio value preservation as also other benefits of long-term investing. In case the time horizon of investment is three years or more, debt products which carry higher yields such as SDL funds or Fixed Maturity Plans with a portfolio yield of 7% plus could be invested into. At the end of the period, which is after three years, one will be able to get the benefit of indexation too which makes for a virtually tax-free return higher than tax frees by approximately 150 basis points.
For optimum results from the investment portfolio, it is important not only to reduce duration with the rise in interest rates, but it is also equally important to switch back to the long end of the curve as soon as interest rates stabilize, and it is time to capture the higher yields for the portfolio. It may not be always possible to capture peak yields. What is more doable is to move in as soon as the level touches reasonably high levels based on historical averages on the benchmark. Studies have shown that once an investment is done at levels above the historical median, the likelihood or probability of the investment making a high single-digit return is very high. However, it is also important that a favorable macro environment is a prerequisite for performance from fixed income portfolios.
Yet another thing to reckon with is credit risk. It is highly likely that investors may be swayed by the high yields offered on low credit papers which may look very tempting. But quite often credit risk-related factors are triggered in rising rates scenarios because of two reasons. The first cost of borrowing goes up and therefore, the cost of funds, and liquidity may also be a casualty in such situations. Second, rising rates may impair the debt-servicing capacity of borrowers. This calls for better diligence on the credit risk front.
The key to checking the health of the portfolios is to do comprehensive reviews on a monthly or quarterly basis. Such reviews should be carried out by experienced portfolio or investment advisors. The more frequently and effectively such reviews are done, the better it is for optimizing portfolio efficiency.
(Joseph Thomas is Head of Research at Emkay Wealth Management)