High Inflation causes rising interest rates, and both of these factors move in the same direction. When inflation threatens to go above the RBI's target (typically 4% with a +/-2 levy), policymakers start to increase the minimum interest rate at which banks borrow from the RBI, which raises borrowing costs throughout the economy by limiting the availability of money(read liquidity) in the economy. The CPI-based inflation rate for May 2022 was pegged at 7.04%. Keep in mind that the Repo Rate and borrowing interest rates are interconnected.
Many investors seized the chance of low interest rates to leverage their benefits by borrowing to invest. Utilizing resources outside of your own to generate wealth beyond your capacity is known as leverage. When the economy was flooded with liquidity and low prices or distressed sales dominated the market during the pandemic, many investors used leverage to enter the real estate, financial, and commodity markets. Though using leverage to grow your wealth is a great strategy when interest rates are low, overleveraging can put your portfolio at serious financial risk if interest rates are abruptly raised.
My friend Raj, too, eagerly jumped on board and allocated a sizable portion of his holdings to real estate. But due to the nature of his loan's interest rate, which was floating (like most lending rates), the current interest rate hike has impacted his EMIs and raised his total amount borrowed. In a similar vein, investors who overleveraged to buy stocks or bonds are currently bearing the brunt of volatility coupled with interest rate hikes.
Here's an example of the impact in the real estate scenario: Assuming a loan outstanding of Rs 1 crore for a period of 10 years at 7.0%. At the onset, his EMI at 7.0% was Rs. 1,16,108 while the total interest payable over the 10 years was Rs. 39.33 lakhs.
Post the interest rate hike, assuming all factors remain constant, let's take a minimal 1% increase in interest rates. This move will push his interest burden to approximately 8%. Now his EMI burden has increased to Rs. 1,21,328, while the total interest payable over the next 10 years goes up to Rs. 45.59 lakhs.
Due to this sudden and unanticipated increase in interest rates, many investors are currently paying more on all their EMIs, equally applicable to car loans, 2-wheeler loans, personal loans, etc.
What can Raj do to better handle his debt?
If Raj wants to keep the EMI the same as it was before, he can either extend the term or, if he has extra funds available each month, he could increase the EMI outlay. Another option is a lower interest rate refinancing of his outstanding loan with a different lender.
As banks will charge higher interest rates for new loans, those who intend to apply for loans may end up having to pay higher EMIs. Existing borrowers will also end up paying higher EMIs, particularly those who chose floating interest rates.
This paradox of rising inflation, rising commodity prices, and subsequently adopting a tight monetary policy may prolong market volatility for some time.
Protect your portfolio from inflation
As an investor, this is the time to review your investment portfolio in tandem with your financial advisor. Take a close look at your asset allocation, especially across industries in your diversified funds and even your thematic funds.
Commodities
Commodities as a broad category, which includes oil, natural gas, precious metals, electricity, or even foreign currency and more, are highly volatile in high inflation, high-interest rate scenarios. Demand and supply are key factors in these businesses, and the ongoing conflict between Ukraine and Russia may significantly alter them. Keep a check on your portfolio’s exposure to commodities.
Alternate Investments
Affluent investors often shift their attention to alternate investments when market volatility is high and unpredictable. They choose tangible assets like gold, silver, and real estate to invest in. When inflation increases, property values and rental income typically increase. Some choose to invest in real estate or pick a hybrid asset for fractional investment in large commercial properties to gain from the upswing.
Bonds
When one side of a seesaw rises, the other side falls, just like bond prices and interest rates do. In a similar vein, bond prices decline when interest rates do, and vice versa. Variations in bond prices depend on when a bond will mature. Bond prices fluctuate more when the tenure is longer. Since longer-term bond yields have already risen in anticipation of future rate hikes, it is widely expected that if the RBI raises rates further, short-term bond yields will rise more than they have thus far.
When investing in debt, one can stagger payments rather than make a single, large payment into a fixed deposit or a single bond at the current rate because these payments may increase in value in the future.
Time in the market
During such periods of high volatility, investors frequently have the tendency to time the market. Avoid this inclination by adhering to your asset allocation strategy and staying away from decisions that are based on current trends. Yes, build on your cash reserves and invest more money when prices are lower, but in a staggered manner. Ensure to keep your risk appetite in check and avoid overextending yourself. Keep in mind that markets are cyclical by nature, which means that periods of strong performance are likely to be followed by periods of underperformance or poor performance and vice-versa.