Rising interest rates make it imperative that fixed income investments or portfolios 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 fluctuations in interest rates. In fact, all asset classes, including equity investments, are equally affected by rate changes.
As interest rates rise, the value of fixed income portfolios gradually declines, and the highest decline occurs at the longer end of the curve, or in longer-term or longer-term instruments. The longer the duration of the portfolio, the greater the loss of value, and therefore, the obvious action that needs to be taken is to reduce the duration of the portfolio. In other words, one needs to stay on the shorter end of the curve or invest in instruments with short maturities so that the loss of value is minimized. This is one of the primary things a portfolio takes action against rising interest rates. However, at some point in time, even short-term portfolios or instruments can be adversely affected, albeit 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’s treasury bills etc. This change always anchors the portfolio to relatively low returns for some time.
One way to keep the portfolio more stable is to move to floating rate instruments. These instruments come with a floor and a range in coupons, and the coupons are reset at periodic intervals based on fluctuations in the benchmark. As the yield on the benchmark goes up or down, the coupon on the instrument you hold will also reset. Any increase in returns or decline in returns will be reflected in the coupon. I have many instruments mutual fund Space which helps in portfolio value protection and also other benefits of long term investment. If the investment tenure is three years or more, one can invest in debt products that have high returns such as SDL funds or fixed maturity plans with portfolio yield above 7%. At the end of the term, which is after three years, one would be able to avail the benefit of indexation, which gives tax-free returns more than tax-free by about 150 basis points.
For optimal results from an investment portfolio, it is important not only to shorten the duration as interest rates rise, but it is equally important to switch back to the longer end of the curve once interest rates stabilize, and it is time to move back to the portfolio. To get high returns. It may not always be possible to capture peak yields. It is more likely to move as soon as the level touches a reasonably high level based on the historical average on the benchmark. Studies have shown that once an investment is made at a level above the historical mean, the likelihood or probability of an investment making a high single-digit return is very high. However, it is also important that a favorable macro environment is a prerequisite for the performance of a fixed income portfolio.
Yet another thing to consider is credit risk. It is highly likely that investors may be impressed by the high returns offered on less credit paper which may sound very attractive. But often factors related to credit risk are triggered in a rising rate scenario for two reasons. The first cost of borrowing increases and, therefore, the cost of funds, and liquidity can also be a casualty in such situations. Second, rising rates can weaken borrowers’ ability to repay their loans. This calls for better due diligence on the credit risk front.
The key to checking the health of a portfolio is to conduct comprehensive reviews on a monthly or quarterly basis. Such reviews should be done by experienced portfolio or investment advisors. The more frequently and effectively such reviews are conducted, the better it is to optimize portfolio efficiency.
(Joseph Thomas is Head of Research at MK Wealth Management)
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