Managing interest rate uncertainity imperative for fixed-income investors

There is no denying the fact that yield curve or interest rates in common parlance are in a structurally declining trend across the globe with India being no exception. However, the sharp cut in rates over the a shorter period in last few quarters has woken up fixed income investors primarily the aging population who survives off the income from fixed deposits, post office saving schemes and other debt products to this reality. As these regular cashflows have started to decline, they need to re-align the portfolio strategy for future to avoid the purchasing power being swept off from them gradually.

Most of the working population is no stranger to the fact that interest rates in India have been on a structural downward trajectory something that I have experienced more closely over the last 12 odd years. While its a reason to rejoice for many of us particularly the working class who saw the houses, cars and other big ticket purchases become more affordable with the EMIs going down, it has brought about tell tale signs of nervousness in a different section of the society – the retired population who essentially survive off the interest earned on next egg amassed during the working years. While a bit adventorous ones may have a little more balanced portfolio with some equity exposure but I tend to believe that majority of people are playing it safe through fixed income products which give them regular cashflows for meeting expenses. Atleast this has been my experience through interactions with my relatives, friends parents and vice versa : ) and know it for a fact for my own folks.

In this situation while many would still have their expenses covered and some savings been reployed still, am not sure how long can this really sustain. The reasons being that most central banks are in an expansionary mode thus not wary of pumping liquidity in the economy – while there are various interlinkages and counter-balancing measures being looked at but the most common sense suggests that interest rates are a function of demand and supply of capital. Thus, if there is enough supply being created and demand yet to be fully established, interest rates will remain sub-dued. This is not at all to suggest that repo would not budge higher from 4% – the decline is not a linear line but carries noises along the curve. So while it would possibly go up and down over a period of time but on a long term basis – it will continue to be on a downward trajectory itself. And combined with likely inflation trend which is likely to be sticky, I do anticipate erosion in purchasing power.

Infact this is the exact similar discussion I have been having at home to nudge the folks to look ahead over next 5-10 years and start changing certain habits – the habit of relying solely on fixed income. I am sure many households, seniors and those nearing retirement are having similar thoughts. There is a need to balance two aspects –

(i) protecting the downside at all cost while ensuring regular flow of income at present

(ii) gradually enhacing the corpus such that it cushions the impact of lower interest rate. Simplistically, if the corpus of Rs.1 crore currently yields 6% pa, its needs to increase to Rs.1.2 crore to be able to generate similar cashflows at 5% rate.

The way to do it is to ensure that the corpus grows at a rate faster than it generates the return – that is a part of the re-investment that happens after meeting current expenses be not ploughed back into fixed income but in equity to let it compound at faster rate. Taking the previous example forward, the following workings make it clearer:

Draft working based on certain broad rule of thumb workings to highlight the risk of purchasing power erosion in a fixed income only portfolio.

The core portfolio stays in fixed income which generates regular flow but incremental investments are being channeled to equity such that investors is better prepared to manage the erosion in purchasing power brought about by declining real interest rates over a period of time. As equity investments may not generate immediate returns and may require a longer time to hatch – its important to leave this basket untouched. Furthermore, the portfolio rebalancing can happen periodically with some money moved from equity to debt when investor feels that returns on debt portfolio are falling short of covering the regular expenses as well.

The next important aspect is about the best route for equity investments which should be guided by minimising the transaction costs, ease of transaction and sticking to index / large caps funds. The best way is to operate through MFU online or any other direct platform so as to avoid paying any commission to the platform. Since the return on fixed income is most likely periodic, adopting a SIP route is the best way forward.

Disclosure: I am not a SEBI registered investor advisor. The views expressed our based on self learning which has helped me bring sanity in personal financial matters.

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