How to invest in a period of rising interest rates
1 min read . Updated: 19 Dec 2022, 10:36 PM IST
PremiumThe ‘risk’ assets have to earn more to be competitive. This changes the dynamics of investing across asset classes.
Interest rates influence investing decisions. A risk-free rate of interest (assuming a bond issued by the RBI) can be considered the lowest cost of capital and also a metric against which you will measure the performance of your returns. Essentially, you keep asking one question — all the investing that you are doing, is it getting you a better return than the risk-free investments?
You should get more returns in proportion to the risk you take. When interest rates are going down, this benchmark of risk-free returns is also going down, so it makes other investment avenues like stocks, real estate, and private equity more rewarding, relatively. But now, after a relatively long period of low-interest rates, the interest rate cycle is moving upwards. The ‘risk’ assets have to earn more to be competitive. This changes the dynamics of investing across asset classes.
Bonds look better : Bonds are designed to do well when interest rates start a downward trend and they suffer when interest rates rise. If you buy a bond in a period of high-interest rates and sell it in a period of low-interest rates, your returns on the bonds are higher than the interest the bond would pay. This is because when interest rates fall, the new bonds issued in the market carry lower interest rates. But you already hold a bond that is paying higher interest rates. Because of the higher interest rate attached to your bond, its value (and price) increases. This price appreciation generates higher returns for you. There are times when equities struggle to outperform bonds. The question that will determine how and when bonds would do better is — will interest rates stabilize at this point, increase or decrease?
Equities fight an uphill battle: Businesses (equities) generally suffer due to higher interest rates. If the interest rates go up, the cost of capital for businesses goes up. This further increases interest expenses, lowers profits and decreases a business’s capability to invest in growth. Markets see these dynamics clearly. When interest rates rise, equities are re-rated and stock prices, especially of high debt companies, are under pressure.
Around 2013, due to lower realized returns (Ebitda per ton), steel companies were not able to cover the interest cost of the loans they had taken. Many steel companies ultimately ended up in bankruptcy courts. These unviable businesses of 2013 became viable during periods of lower interest rates. The bankrupt steel companies got acquired by players who could raise fresh debt at (now) lower interest costs. For example, Tata steel took over Bhushan Steel, and Arcelor took over a bunch of companies. There were certainly other aspects of these corporate takeovers but the ability to service debt, and raise new debt, was a key influencing factor.
It’s not all bad; higher rates are often good for businesses because they kill weak competitors. Weaker companies find it difficult to service existing debt, or raise more debt, making them non-competitive. For example, PSUs will do good in a high interest rate environment since they can raise debt relatively cheaply, based on their quasi-government creditworthiness while their competitors pay a risk premium for the same credit line.
Catching the interest cycle: Interest cycles do not change in a hurry. It’s a slow and gradual process . Historically, we have seen that high-rate cycles do not last too long and usually turn around in 2-3 years. We are already at about six months in this cycle. The cues of a changing interest rate cycle will come from inflation trends. When inflation trends are down and central banks pause interest rates hikes, then you know that the cycle has started to turn. There’s a strong political angle to it as well — governments may rather be happy to see growth stall to avoid an increase in inflation. Hence, interest rates should stay up much longer than they have to.
Like always, the market gives cues on how it thinks inflation will play out. For instance, the 10-year yields in the US are already at 4% while 2-year yields are at 4.5% which shows that long-term yields are lower than short-term yields. This discrepancy in yields indicates that the market thinks inflation will be lower over the next 10 years but it will be higher in the next two years.
Sure, bonds will give more interest and the benchmark to beat risk-free returns will rise. Yet, there will always be businesses worthy of investing in higher interest rate periods. The lens for looking at the opportunities needs to be changed since we can no longer ride the low interest wave for price appreciation of assets.
Deepak Shenoy is founder & chief executive officer at Capitalmind
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