Topic 4: UNDERSTANDING THE IMPACT OF RISING INTEREST RATES

The RBI usually increases interest rates when they expect inflation to rise above their target rate. An environment of low-interest rates supports economic growth, while higher interest rates tend to moderate economic growth.

On Equity Markets

Higher interest rates can be damaging to the equity market. As the interest rate increases, the cost of borrowing money increases for both corporates and individuals, which typically leads to a curb in their spending. Corporates tend to delay their capital expenditures, while individuals, on the other hand, are left with less disposable income for spending. Over time, higher interest costs and less business could mean lower earnings for corporate, leading to a slower growth rate impacting their stock price.

Another approach to understanding the impact of rising interest rates on the equity market is through intrinsic value. In theory, a company's intrinsic value is the net present value of its future profits. The rate applied to discount future profits becomes critical while computing the present value. As the interest rates increases, this discount rate also increases and leads to lower intrinsic value.

Rising rates are associated with the falling equity market, but that is always not the case. Several other factors, such as future growth prospects, liquidity, and investor sentiment, can support the market.

On Fixed Income Market

A fundamental principle of bond investing is that interest rates and bond prices generally move in opposite directions. When interest rates rise, prices of bonds fall. That’s because government/corporates will have to issue new bonds in the market at higher interest rate payments. Thereby, existing bonds will decline in price to make their comparatively lower interest rate payments more appealing to investors.

Higher interest rates are not always so bad for long-term investors.

1. Re-investment: Higher interest rates offer long-term investors a chance to make higher long-term returns. Any maturing debt or coupon payments received can be invested at higher interest rates. Even for debt mutual funds which target a particular maturity profile range can reinvest any new inflows at a higher interest rate

2. Higher interest rates have a higher scope of beating inflation

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