The Era of Low Interest Rates – The Grass IS Greener on the Other Side
Economy 410 views
Let’s face it – low Interest Rates are here to stay. The question is, what does one do to prevent a fall in returns earned on savings. A Smart Investor sees this as a trigger and an opportunity to invest in more productive instruments. However, there’s no point being reactive. It’s important to carefully analyze options and devise a Personal Investment Plan. So, let’s start by getting down to the First Principles.
It is the aim of every Saver/ Investor to derive maximum returns from his/ her investment. Rate of return on investment broadly depends upon two parameters: ‘Inflation’ and ‘Rate of interest’. ‘Inflation’ is defined as a situation where ‘too much money is chasing too few goods’ leading to a rise in price level due to the excess of demand over supply. The reverse of inflation in called ‘Deflation’ which is far more disastrous as compared to inflation as it hampers growth.
Rate of Interest is managed by the Central Bank of the country (in our case Reserve Bank of India). Generally, interest rates and inflation move in tandem, low inflation leading to low interest rates and vice-versa. In India RBI monitors the rate of inflation and adjusts its benchmark rate (Repo rate) based on its future projection of inflation. A key thing to remember though is that central banks do not set market interest rates; rather their own reference rate and any associated monetary operations influence market rates, and are influenced by them. In India, the most common indicator of retail inflation is Consumer Price index (CPI), which has started to move down, providing a trigger for a Low interest rate regime in the future. RBI has already reduced the reference Repo rate by 1.50% from 7.75% to 6.25% in the past 24 months (it is now at its 6-year low). The impact of this reduction is evident on the Deposit & Advances (Loan) interest rates charged by Commercial banks. The maximum interest rates offered by most frontline banks today is in the range of 7-7.5%. The reduction in deposit rates is detrimental for long term investors who invest their savings in Bank fixed deposits. The upside is that it makes the personal loan & home loan interest rates more attractive.
Traditionally Bank deposits, Govt. Bonds and Small Saving schemes (like Post office schemes, PPF etc.) have acted as a safe investment for a majority of investors in the past. But the govt. has now linked the Interest rates on these deposits to the benchmark rates, leading to a reduction in interest rates of various Govt. schemes in line with the benchmark rates. Thus, fixed income investments are turning un-attractive in the long run. What should long term investors do in such a scenario? The investors are advised to create a balanced portfolio to overcome the risk arising due to the falling interest rates. Ideally, an investor’s portfolio should consist of: Traditional investments, Market based investments & Alternate investments. Traditional investments like bank deposits have a high element of Safety/ liquidity and should form 20-30% of the overall investment portfolio. A major chunk in a falling interest rate scenario should comprise of Market based investments (Equity & equity related investments). One may invest between 30-70% in equity based instruments, depending on one’s risk appetite. For example, young investors can invest more in equity whereas retired investors can invest less. An investor also needs to invest 10-15% of the portfolio in alternate investments such as bullion (Gold & Silver) which serve as a hedge for the portfolio against inflation.
Most financial advisors recommend building a long-term equity portfolio because it proves to be the most efficient investment in a low interest rate regime. Historically, in India equity returns have been in excess of 14% per annum when calculated over the long term (5 years and above). These returns can be much higher in a low interest rate regime. Let us try to understand how returns from equity markets are generated. Investors hope to get 2 types of returns from equity investment: Dividend payouts and Capital appreciation. Equity market indices are the barometer of the economy and flourish in a low interest rate regime, because profits of companies increase at a faster pace when interest rates are low. And fundamentally markets align themselves to increase in Corporate profits. Secondly, in India the tax structure for equity investments (including investment in equity oriented mutual funds) is very attractive. Capital gains on equity investment are fully tax exempt under Long term capital gains (LTCG) if sold after holding period of 12 months and more. On the other hand, interest earned on fixed income investments is subject to tax as per individual’s tax slab. Thus, it makes little sense for individuals in the highest tax slab to invest heavily in bank deposits. In the recent past, mutual fund investments have seen a substantial growth irrespective of market trend, but still less than 4% of the Indian population has exposure to equity investment.
Alternate investment in bullion also can be looked into to serve as a hedge against inflation and market volatility. Bullion shows a positive trend in times of economic upheavals and safe guard our portfolio. Financial advisors recommend investment in alternate assets to the extent of 10-15% of the total portfolio. Keeping in view the likelihood of a low interest rate scenario unfolding in India over the next couple of years, investors are advised to create a balanced portfolio with a large chunk of equity investment. For investors who have little knowledge about equity markets it is advisable to chose the Mutual fund route through Systematic Investment Plan (SIP). You can be assured of a decent return, as MF investments are highly regulated by SEBI to ensure safety of your funds. Other than Safety and long term gains MFs also ensure a fair amount of liquidity to your portfolio.
In short, the changing economic climate and the fundamental changes it brings can be seen as a blessing in disguise. With a bit of initiative and proactivity, one can not only adapt, but also get into the habit of wealth-creation, shedding the risk-averse or ‘rent-seeking’ savings-style prevalent in the salaried class for so long. We dare say it’s too risky to take no risk whatsoever.