Your money and Interest Rate movements

In this article you will read about

• Why interest rate matters
• How interest rate change impact your savings
• Interest rate and bond price relation

The fall and rise of interest rates always makes for news, leaving mixed outcome among savers and investors. Let’s first understand what is interest rate – interest is what you pay for borrowing money, and what banks pay you for saving money with them. So, if you have kept Rs 100 in the bank earning 4% annual interest, a year later your savings will become Rs 104. World over central banks decide interest rate in their countries, the Reserve Bank of India (RBI) being the central bank in India fixes a base rate or an interest rate, based on the inputs and views of its Monetary Policy Committee (MPC).

The RBI MPC’s objective is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth while targeting inflation. One way to maintain price stability is to adjust short-term interest rates to maintain inflation. The impact of change in bank rate is felt by all of us in some way or the other. For instance, when rates go up, cost of some products go up, like the interest on loan goes up.

In contrast, lower interest rate is used as an economic stimulus by making it cheaper for businesses and consumers to borrow money. But low interest rates can also potentially encourage overspending, which in turn could lead to rise in inflation. By adjusting the interest rate, the RBI uses its control over interest rates to try and strike a balance between economic growth and inflation.

The impact is also on investments, especially debt mutual funds. Unlike equity investments, where you own part of the business; when you invest in debt – your investments are actually treated as a loan. While an equity investor receives a dividend, a bondholder receives interest on bonds, which is why interest rate movements have an impact on investments in debt funds.

There are three components of a bond: the coupon rate, which is the promised interest rate paid at a fixed interval to the bondholder, the par value which is the principal amount that will be returned by an issuer to a bondholder at maturity. And, maturity, which is the date on which the bond expires assuming all promised payments are made. Let us understand this with an example where a company issues a bond with a par value of Rs 1,000 with a coupon rate of 7% (paid annually) and a maturity date of four years. In this case, investors of the bond will receive the interest payment of Rs 70 for each of these four years. And, at the end of the fourth year, they will receive back the bond's par value of Rs 1,000.

At the time of issue, the coupon rate and yield to maturity (YTM) are the same. However, once the bond starts to trade in the secondary market these two start to change. If the bond yield is less than the bond’s coupon rate, then the bond will trade at a premium. Likewise, if the bond yield is more than the bond’s coupon rate, then the bond will trade at a discount. The impact of changing interest rates also plays a role, leading to an inverse relation between interest rates and bond prices.

To understand the impact, assume the interest rate of Rs 1,000 par value bond from the earlier example rises to 8%, which means the demand for your bond, will decrease. So, in order to sell the bond, you need to offer the bond at a discount, which is less than Rs 1,000. In contrast, if the interest rate of the similar bond falls to 7%, the demand for the bond will increase; making it worth more than its par value of Rs 1,000 or it could sell at a premium. But, not all bonds are impacted the same way; bonds with shorter maturities tend to be less affected by interest rate fluctuations, while bonds with longer maturities generally fluctuate more.

While investments in equities are not directly impacted by interest rate movements; they do tend to have a trickle effect indirectly. What you need to know as investors is that interest rate fluctuations can affect investments in different ways, and there is no single action that you should take because of the rate change. You should focus on your financial goal and investment plan and if at all use interest rate fluctuations as a tactical move to change your investment portfolio.

Next steps

1. Check how rate change impacts your portfolio
2. Identify investments that are vulnerable to rate change
3. Make changes to your portfolio if it will be impacted