How will RBI's Policy Rate Hike Impact Your Investments?

The RBI had last revised the policy rate on May 22, 2020, in an off-policy cycle to boost demand by dropping interest rates to a historic low in the wake of uncertainty surrounding the COVID-19 pandemic. The Reserve Bank of India recently took everyone by surprise by raising the key interest rate by 40 bps in an off-cycle policy review meeting. Further, the Central Bank also decided to increase the cash reserve ratio (CRR) by 50 basis points to 4.5%, effective from May 21, 2022.

Mr Shaktikanta Das, RBI Governor, said in his statement, "As several storms hit together, our actions today are important steps to steady the ship. I would, therefore, like to emphasise that our monetary policy actions today aimed at lowering inflation and anchoring inflation expectations will strengthen and consolidate the medium-term growth prospects of the economy." In order to keep the Indian economy resolute on its course to sustained and inclusive growth, inflation must be tamed.

The RBI retained the Repo rate at 4% in its April 2022 policy review, but the situation has worsened, particularly on the global and inflation fronts. The headline CPI inflation rate increased to 6.95% in March 2022, exceeding the RBI's upper tolerance ceiling of 6%. The upside risks posed by global forces to India's inflation trajectory were hence the basis behind this policy rate hike.

The increase in the Repo rate and CRR is the start of a rate hike cycle, not a one-time increase. The RBI wants to keep inflation under control, which is already close to 7%, as well as manage and monitor money flow into the banking sector. According to experts, the RBI will continue to further hike in Repo rates to reach the pre-pandemic level of 5.15% by March 2023.

Join Now: PersonalFN is now on Telegram. Join FREE Today to get ‘Daily Wealth Letter’ and Exclusive Updates on Mutual Funds

Let us see how the RBI's Policy rate hike affects your investments:

Fixed Deposit Investments...

The rate hike was welcomed by fixed deposit (FD) investors, as lenders reprioritised their FD rates in certain categories in response to the RBI's decision.

Given that there have been a lot of uproars recently regarding fixed deposits (FDs) with record-low interest rates, this is about to change. Fixed deposit rates are expected to rise, putting an end to the low-interest-rate environment. In order to benefit from higher interest rates in the coming months, a depositor may now consider locking funds in shorter-term FDs.

Some banks have started raising their fixed deposit rates, once banks raise their fixed deposit rates, new deposit holders will enjoy higher interest rates. Existing deposit holders, on the other hand, will lose the benefit of the increase in bank deposit rates. However, they should avoid premature withdrawals to benefit from growth rates by shifting their FDs, as banks charge 30 to 100 basis points of the interest rate as a penalty.

As a result, don't put all your money in long-term FDs for the time being. The rate hikes have only recently begun. So, avoid locking your deposits for the long term and wait for rates to increase further; meanwhile, you may consider investing in short-term FDs.

Mutual Fund Investments...

Investor sentiment will be impacted first as a result of the rate hike. The stock markets typically go down with the RBI's policy rate hike, as with the increase in rates, the rate-sensitive companies and sectors get impacted, thus impacting equity fund returns in the short run. Accordingly, the market led to mayhem within an hour of the announcement of the policy rate hike.

Stock markets are influenced by more than just interest rates. When there is plenty of liquidity, equity markets do well. If the RBI tightens the screws by raising interest rates, the Indian stock markets will be negatively affected. Following the RBI's action, several banks intend to raise their lending rates, thus making loans more expensive. When interest rates rise, companies will have to pay a higher interest rate to borrow money, indirectly impacting the equity fund returns.

In addition, the US markets may experience headwinds over the next few months. To tackle the soaring inflation, the US Federal Reserve increased interest rates by 50 basis points to 0.75%-1% in the May 2022 meeting, thus impacting the markets across the globe.

Under such conditions, very large companies that have very little debt are likely to do well. It means your large-cap mutual funds are likely to perform better in the near future. If you have investments in mid and small-cap mutual funds, prepare to confront some volatility since the mid and small-cap companies will have to weather the storm. Also, don't panic if your schemes are in the red, and hold on to your regular investments.

As a result, equity returns may suffer in the short term if no new positive triggers emerge and there are many negative undercurrents such as war, inflation, and so on. If you are an equity investor, scale down your return expectations from equity mutual funds for the time being.

Now, what about your debt mutual fund investments? As you may be aware, bond prices are inversely correlated to yields; an increase in interest rates puts debt-oriented Mutual funds at risk of losing value. When interest rates go up, bond prices decline and vice-a-versa.

After the RBI's announcement, the 10-year bond yield, which had been steadily rising in the recent months, inched up to 7.40%. As a result, the net asset value (NAV) of debt mutual funds has fallen sharply, particularly for medium and long-duration funds. An increase in interest rates will have a negative impact on debt funds with a longer duration.

If you have to park fresh money in debt funds, stay on the shorter side of duration as it has a low mark to market impact in a rising interest rate scenario. Stick to debt fund categories like liquid, ultra-short duration, low duration, etc. Investment in short-term debt funds will benefit investors with an accrual strategy, thus helping them take advantage of reinvesting the maturity proceeds at a higher interest rate in the future. Do note that these short-term funds may face short-term volatility, but they may recover in time. Ensure your suitability based on your risk profile, investment horizon, and objectives before investing.

[Read: RBI Hikes Interest Rate. What Should be your Debt Mutual Fund Strategy Now?]

On the other hand, the Repo Rate hike by the RBI will ensure that lenders increase their rates on various credit facilities, including home loans. Commercial banks obtain short-term funds from RBI at this repo rate. When the RBI hikes the policy rate, it becomes expensive for banks to acquire funds from the central bank, which in turn forces these lenders to raise their lending rates as well.

However, this rate hike is bad news for borrowers; several leading commercial banks have already hiked the lending rates for home loans. For example, HDFC Ltd. announced a hike in its Retail Prime Lending Rate (RPLR) on Housing Loans by 30 basis points for all borrowers, existing as well as new. The revised lending rate of the bank shall be effective from May 09, 2022, for new customers and from June 01, 2022, for all the existing customers of the bank.

[Read: How RBI's Repo Rate Hike will Impact your Home Loan EMIs]

Therefore, you should brace for the impact of the RBI's Repo Rate hike, be prudent with your investments and manage your finances effectively.

PS: If you wish to select actively managed worthy mutual fund schemes, I recommend that you subscribe to PersonalFN's unbiased premium research service, FundSelect.

As a bonus, you get access to PersonalFN's popular debt mutual fund service, DebtSelect.

PersonalFN recommendations go through our stringent process that assesses both quantitative and qualitative parameters, providing you with Buy, Hold, and Sell recommendations on equity and debt mutual fund schemes. Read here for more details...

If you are serious about investing in rewarding mutual fund schemes, Subscribe now!

Warm Regards,
Mitali Dhoke
Jr. Research Analyst