EspressoLogy

What are the best investment options in a rising interest rate environment?

Geopolitical tension, especially the ongoing Ukraine-Russia war, has disrupted the global supply chain, leading to inflation surging beyond acceptable levels. Amid fears of runaway inflation, central banks globally have resorted to monetary tightening by hiking interest rates to suck excess liquidity from the system.

On June 8, the Reserve Bank of India (RBI) hiked the repo rate by 50 basis points (bps) to 4.90% to combat high inflation. Consequently, the standing deposit facility (SDF) rate stands adjusted to 4.65%, and the marginal standing facility (MSF) rate adjusted to 5.15%. 

This was the second rate hike since August 2018, following the unscheduled rate hike on May 4 where the RBI had hiked the repo rate by 40 bps and the cash reserve ratio (CRR) by 50 bps.

Stock prices tend to have an inverse relationship to interest rates. Rising interest rates increase the borrowing costs for corporates, which negatively impacts their earnings. As a result, the market expects corporate earnings to decline in the future, which leads to a fall in stock prices. This can significantly impact our investments as most sectors, especially those operating with high leverage, get negatively impacted in a high-interest rate environment.   

However, certain sectors and companies also benefit from rising interest rates. As a result, their prices tend to go up during this time.

Let’s take a look at the best investment options in a rising interest rate environment:

Cash-rich companies

As the interest rates rise, cash-rich companies tend to benefit with more earnings on their cash reserves. This surplus cash helps them to face uncertainty in the markets. As an investor, you may look for cash-rich companies or those with a large percentage of book value as cash amid times of increasing interest rates.

Financial stocks; banks, mortgage, insurance companies

Banks and mortgage companies are the direct beneficiaries of rising interest rates as they earn money from interest. When central banks raise interest rates, the credit cost in the economy rises and these financial companies see improvement in interest income and profit margins.

Similarly, insurance companies have steady cash flows and are bound to hold lots of safe debt to back the insurance policies they write.

Low debt or Debt-free companies

Companies with low debt-to-equity ratios are considered less risky amid uncertainty. The impact of rising interest rates is lower on them as they have a low/negligible amount of debt which has a minimal impact on their profitability.

Value stocks

Value stocks whose stock price is less than their intrinsic value. Simply put, they are trading at a price lower than their true worth. Hence, a stock trading at Price-to-book (P/B) ratio of less than 1 becomes a solid investment option in rising-interest rate environment as they are already trading at a discount, which limits the downside. Another approach to value investing, would be to look for stocks that are trading at a relatively lower valuation ratio compared to its peers or industry benchmark.

Floating Rate Bonds

Floating rate bonds bear variable interest rates that reset at regular time intervals. These bonds reduce the risks of volatility in interest rates and therefore tend to perform better than fixed-income investments.

Floating rate bonds provide a hedge against potential inflation. While the bond’s yield varies with the change in the reference rate of interest, the spread generally remains the same.

In order to maximise returns, it is advisable to diversify your portfolio and try making it shock-proof from the changing external macroeconomic environment. Amid rising interest rates, you need to understand its impact on sectors and invest in companies that do well when the rates are high.

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.