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How to be a smart investor
Arnav Pandya | February 18, 2008
The fear of an economic slowdown has led to increased attention on interest rates movements all over the world. Countries like the US and UK have already witnessed aggressive rate cuts to counter the threat of recession.
India, on the other hand, is still grappling with the inflation versus interest debate. The Reserve Bank of India [Get Quote] governor Venugopal Reddy has been constantly reminding bankers that interest rates should be kept tight to control inflationary pressures.
However, as an individual, it is important that you understand the way interest rates are going. This would help you to take advantage of the rate movements, both in case of a home loan or personal loan interest rates or even, investments in debt products.
Before trying to understand the exact impact of interest rate movements, it's important to look at the circumstances that lead to such a situation. In the first case, the rate cut is influenced by RBI through its various indicative rates like the repo and reverse repo.
By tinkering with these two, the apex bank indicates its stance on the interest rate scenario. The banks, accordingly, change their prime lending rates (PLRs). If you are someone who follows interest rates carefully, here are a few finer details to help devise strategies accordingly.
Before a fall
There are two main strategies that can be adopted by an investor before an interest rate fall. The idea behind this move is to ensure that the dip will lead to a gain for the investor, in terms of a higher rate of return.
That is, if you are an investor in bonds, a falling interest rate means rise in the value because of a fall in the yields. So the debt instrument being traded will rise in value. So debt mutual funds will see a rise in the NAV.
The rise is sharper for those funds that hold long-term instruments, as compared to those, that hold short-term instruments. When the investor expects the rates to fall, getting into a long-term income fund or a long-term gilt fund will lead to a jump in returns, but doing the same thing after a rate fall will not get the same benefit.
Another strategy that you can use is to lock yourself in a fixed rate instrument before the rate falls. This will ensure that the fixed rate return that a person has entered into will still be given, even though the rates have fallen.
Since this is a fixed rate, and not floating rate instrument, there cannot be a resetting of the rate. A good example of this kind of investment is a deposit that earns a higher rate of interest or a bond.
After a rate fall
Once the interest actually falls, you should look at the situation differently. That is, unless there are expectations of a further cut, the same strategy will not work for you.
However, a way to tackle this is to look for fixed return instruments that have a rate, higher than the prevailing interest rate. More importantly, look for instruments that provide an assured rate of return for the long-term.
Often small savings instruments fall under this route because the change in rates in them happens after a long time. Hence, they are good in a falling interest rate regime.
Another strategy that you can use to take advantage of the short-term change is to try and invest through a fixed maturity plan or any similar instrument that offers higher returns.
The only thing in such a situation is that the higher rate might be available for a specific time duration after which the person will have to look out again for newer instruments.
Rise in rates
Over a longer time frame there will be times when interest rates rise or they are expected to rise. Faced with such a situation a person would need to play a patient role. Exposure to debt products in a rising rate scenario has a direct as well as an indirect impact.
If the investment is in a traded instrument, either directly or through a mutual fund, be prepared for a dip in the value. Investment in a floating rate fund reduces this impact, but does not completely eliminate it.
While looking for other fixed rate instruments, waiting for the rise to come will ensure that the person is able to invest in a bond or a deposit that carries a higher rate of interest.
In other words, both rise and fall in the interest rates offer opportunities for the investor to make money. Be a smart investor for best results.
The writer is a certified financial planner