How to to protect your stocks from rate spikes

Stock Market | admin | June 17, 2011 at 6:42 am

In its attempt to contain the monster that eats into our savings, the Reserve Bank of India (RBI) has raised interest rates five times since March this year. Taking the cue, banks too have followed suit and raised interest rates just a few days ago. Last week, in its policy review, the central bank left rates unchanged, merely reducing the SLR to 24% from 25%.

However, this is certainly not the end of the taming of inflation story. "We are in a rising interest rate scenario and there is a consensus amongst market players that the RBI will hike rates in January ," says Sadanand Shetty, vice-president and senior fund manager (equity), Taurus Mutual Fund.

So what does this rising interest rate mean for the stock market investors? And why do money market participants bet on further rate hikes? As long as the inflation doesn't show signs of easing, the central bank has no option but to hike rates. This is because when interest rates are low, there are more borrowers willing to take loans. This means more money in the system and higher inflation . To reduce the chance of inflation, the central bank raises key interest rates, following which banks too hike rates. The opposite is also true. For example, when the economy exhibits low growth or in times of recession, central banks across the globe lower interest rates which, in turn, forces banks to reduce interest rates.

Consumer Woes :

Rising interest rates have an immediate impact on your monthly budget. You grocery bills will be the first item to show the strain. And, if you have an outstanding floating-rate housing loan, the rise may hurt you more. For example, let's assume you have an EMI of . 28,951 for a . 30-lakh home loan at 10% interest for 20 years. However, if the interest rate moves to 12%, the EMI would go up to . 33,033.

Most people assume that the increase in EMIs would be offset by higher interest rates that they earn on your deposits. However, it's not so simple, as most of the time rising interest rates are usually accompanied with an even higher rate of inflation, thereby reducing an individual's purchasing power. Those who already have loans will have less disposable income as they will have to spend more on interest payments . Therefore, consumption patterns, in general, will see a contraction.

Most businesses need capital to run their day-to-day operations that require a mixture of debt and equity. Companies that carry a huge debt on their balance sheets, and those which need more capital in the form of debt for expansion are the worst affected. This is because when interest rates rise, the cost of borrowing also rises. So, you have to pay a higher interest cost to service that debt. In such a scenario, a company has two options be-fore it: either to pass on the rise in interest cost to the end-user or customer, or absorb the burden itself.

Since it is a competitive market, it is difficult at most times to pass on the increased cost entirely to the customers or end-users . In such a scenario, profits could come down. From an investor's perspective, when profits come down, the stock becomes less attractive to potential as well as existing investors and the stock price falls. "Rising interest rates affect the fundamentals of corporates in the long term," says Anand Shah, head of equities , Canara Robeco Mutual Fund.

Stock Shock:

Rising interest rates generally hit markets negatively. They affect some industries more than the other. For example, investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include automobiles, real estate and the banking sector. A rising interest rate scenario has a higher effect in the long term. "While in the short term, it is liquidity that could help markets tide over, in the longer term, higher interest costs bring down the P/E (price-to-earnings ) ratio of companies," adds Anand Shah.

Investors who favour increased current income compared to waiting for an investment to grow in value and sell later are attracted to investment vehicles that offer a higher rate of return. Higher interest rates can make investors switch from stocks to fixed-income instruments such as bonds and fixed deposits. In addition, high interest rates can have a negative impact on an investor's total finances.

When an investor pays higher interest on his credit card, home loan or automobile loan, he may sell some stocks to pay off some of his high-interest debt. In order to do so, he could sell some of his stocks. Selling stocks to service debt is a common practice and can hurt stock prices.

Sectoral Slips :

"Interest-rate sensitives such as auto and auto ancillaries, banks, and real estate are the first ones to be affected in a rising interest rate scenario," says Suhas Samant, fund manager, PMS, Sharekhan. We have already seen several banking stocks taking a beating in the recent past. The largest of them all — State Bank of India — has lost 22% from its peak price of . 3,515, while ICICI Bank has lost 13% from its high of . 2,520. Bank of India has lost 25% from its high of . 589. Auto stocks too have taken a hit.

Maruti Suzuki has lost 15% from its high of . 1,625. Real estate stocks have also been beaten down as higher interest rates could dampen con-sumer interest. Prospective buyers may feel it safer to continue staying on rent than buying a house. "Construction companies and infrastructure companies that guzzle down huge amounts of cash could be affected," adds Sadanand Shetty "We are underweight on banks, autos and real estate," adds Anand Shah.

Safe Haven:

Sectors such as pharmaceuticals, FMCG and IT are considered non-interest rate sensitive by investors and are safe to park your money during a high rate regime. "You can postpone buying a house, but you cannot postpone buying things like soaps, detergents and toothpaste, which are a daily necessity," says an FMCG analyst at a foreign brokerage house. Similar is the case with medicines, where consumption is interest-rate neutral. "We have increased our exposure to IT from 4% to 6% in our portfolio," adds Samant.

As of now, it looks more likely that interest rates will inch upwards in the near future. Investors are advised to keep that in mind and position their portfolio accordingly.

Source: Economic Times