'Neither a lender, nor a borrower be, goes the adage. In today's rising interest rate scenario, being a borrower can be a scary scenario. Rising EMIs (equated monthly instalments) have been causing a lot of financial and emotional strain on the borrowers. Anyone who has taken a floating rate loan over the last 2-3 years can testify to that.

However, for the lenders, this is a good time to earn handsome fixed returns. For those of you who might have been worried about the volatility in the stock markets, this is the time to check out the fixed income instruments.

Currently the yield curve is almost straight, if not inverted. Hence, while the call rates are around 7.xx% today, the 10 year paper is also yielding approximately 7.xx%.

This means that whether you invest in short-term securities or long-term securities, the interest rate that you will get on either is similar. Which should you choose? Should you invest in short term debt or invest money for a long period?

Floating rate products:

While banks have innovated floating rate products on the loan side, making a floating rate product on the asset side has been left to the customer. If you want a floating rate product, you need to invest in short term (say, 3 month) deposits and keep rolling over the deposits to get a floating rate deposit.

As the interest rates keep changing, the income you earn on your deposits keeps changing. In the rising interest rate scenario, rolling over fixed deposits provide you with a better income.

However, the issue with "rolling over" fixed deposits at short durations is not only the logistical hassle, but also the "reinvestment risk": this risk that interest rates may fall over the period and hence you might get a lower rate in the next period. Hence, people prefer to lock in rates for longer periods of time.

Fixed rate products:

Fixed rate bank deposits have been in vogue for a long time in India. People tend to invest in fixed deposits with a sense of security. However, notice the plight of investors who invested in fixed deposits of 5 years duration, say last year.

They got a rate of 7.5% - 8% while the same bank is now offering ~10% on new fixed deposits of 5 years tenure. This means that the customer is loosing almost 2% - 2.5% of the principal value very year over the next few years.

Intuitively, it is easy to see that if the interest rates rise, then being invested in a fixed security can be a risky proposition: you loose out on the opportunities that time might bring your way. Alternatively, if the interest rates fall and you have "locked-in" a high fixed rate, then you stand to benefit.

What should I do today?

With the sharp increase in the interest rates, what should an investor do?

Review your old fixed deposits: If you have invested in fixed deposits over the last few years, then this is the time to review your investments. Note the rate of return that you are earning on them, which in many case will be between 6% - 7%. Compare them with the rates available today (~9.5% to 10%). Typically, it would make sense for you to "break" your old FD and invest it in this higher interest rate environment. However, do not be greedy in one go!

Invest in short tenor debt: When the direction of the interest rates change is not certain but the rates are on the rise, you should avoid investing in for the long-term. This is because, if you lock in a rate now, you will want to reconsider your decision if the interest rates go up further.

This may not be possible as your money will be locked-in by the bank as a fixed deposit. As the banks face a liquidity crisis, they have started coming up with strict provisions for those depositors who want to withdraw their capital earlier than the maturity.

Review your financial plan: If there is one certainty, in the world of markets, it is that no one can always perfectly time the market. It is impossible for anyone to call the top or the bottom of the market.

Similarly, it is not possible for anyone to predict when - and at what level - will the rise of the interest rates stop. However, when you have made your financial plan, you would have expected certain returns from your investments. Once, you realize that the debt portfolio is meeting your objectives, you should "lock-in" your rates.

Conclusion

The general consensus is that the Reserve Bank of India will raise interest rates at least one more time, if not more. In such a scenario, it is prudent to remain invested in shorter term fixed income investments.

Once there is more certainty and stability around the interest rates, you need to lock in your long-term interest rates.

When you want to invest for a shorter duration, you will find that the fixed maturity plans offered by the mutual fund companies will serve your purpose better than the bank fixed deposits.

The author is Director, PARK Financial Advisors Pvt Ltd, Mumbai. He is an IIM-Ahmedabad alumnus. He can be contacted at info@parkfa.com