Monday, February 26, 2024

How to allocate your assets in a world with rising interest rates

It is perhaps the single most important indicator of the cost of money for the world at large. And that’s because no matter the mild challenge from Japan in the 80s, or China more recently, the US remains the engine of the world. And the financial capital to boot.

And therefore, whatever happens to cost of money in the US, is bound to have repercussions for the rest of the world.

And this is exactly what we are witnessing play out right in front of us today.

The yield on this bond has increased from a low of about 0.5% in July 2020, all the way to 4.86% today. The last time the yield was this high was about 16 years ago.

For some, the end of the rate hike cycle is near. But for many, there’s some more to go.

Bill Gross, co-founder of Pimco, talks of the treasury bond testing 5%.

And Jamie Dimon, CEO at J P Morgan, won’t be surprised if yields hit 7%.

Without getting into where the yield on the 10-year Treasury is headed, the fact is that today interest rates are higher than anytime since many years.

This will of course have implications for India as well – Yes, it will! We have already seen how interest rates on deposits have increased. As I write this, a bank alerts me that they now offer 7% for monies over 5 lakh in a savings account (not even a fixed deposit!).

So even as we see all this transpire around us, the question that needs to be asked is this: Is your asset allocation geared for a higher interest rate environment?

Well, if you are like most people, you have been conditioned for the last 15 years or so to invest in higher risk assets as returns from fixed rate instruments were generally poor (and getting poorer with time).

You were, to use a technical but nice sounding phrase, hunting for yield.

Since returns on fixed deposits were not exciting and government savings schemes less so with every passing year, you had little choice but push into equity funds / equities to make that extra return to plug the gap in your income.

If you were one of the few who were pampered by large institutions, you were exposed to structured products or high-risk credit products or a combination thereof.

Basically, a lot of what you did was because of “there is no alternative”. To make a healthy return, you were forced to take risk, whether you were ok with it or not.

But now, the world has kind of changed. Rather, it’s changing. There is money on the table for people who do not like to take much risk. The point is what you are going to do about it.

You see, there are two ways to look at this.

First, as interest rates rise, the relative attractiveness of high risk assets decreases. To give you a simple example: if you have a choice of 5% fixed return vs a 12% possible return but with risk of capital loss, you would probably still opt for the 12% deal. But what if it was 8% vs 12%? You see, a sensible investor would like to earn a lot more over and above the 8% to carry the risk of capital loss as well. And this higher return expectation basically means lower asset prices (all things remaining the same). This is one of the main reasons why stocks are selling off in the US for instance.

And by the way, the riskier the asset, potentially greater the damage. We have already seen this play out, so you know what I am talking about.

So, if your allocation to risky assets is higher than what your planned asset allocation suggests, you need to think about this. You are carrying more risk than you can probably absorb comfortably if something were to go wrong.

On the flip side, there are your interest bearing/income generating assets in your portfolio. This works in various ways.

As interest rates rise, you lose out on the higher rates in case your money is locked in for longer tenures at fixed rates. In case of instruments like debt funds (with long durations i.e. long term debt instruments in their portfolio), again you take a hit as bond prices adjust lower to reflect the higher interest rates.

If however, your have liquid monies, or monies invested in debt instruments where the interest rate is reset regularly to adjust to market conditions then you are better off. You will automatically start to earn a better return on existing investments.

This is quite straight forward.

The question that arises is that if you have money now, where do you invest when it comes to the low risk part of your allocation?

Well since each of your personal circumstances are different, there is no specific answer.

But to my mind there are few things to consider –

First, leaving money in a high yielding savings account (my reference to the 7% rate above) till it’s clear when and where to lock in a yield for the long term.

Second, investing in extremely well managed debt funds at the top of the interest rate cycle could be another investment opportunity to consider. Here you need to be cautious though as debt funds do expose you to significant risk. If interest rates were to rise further, then you could see even negative returns. Keep that in mind!

Third, some banks are opting special interest rates on slightly longer-term deposits. These too could be a good option, especially for your emergency fund (remember the rules for investing for your emergency fund).

This brings me back to the question – Is your asset allocation geared for a higher interest rate environment?

I think there is a need for you to re-look at everything and be sure, you are not over exposed to high-risk assets. And on the flip side, even for your low risk allocation, you are fully geared to benefit from the higher interest rates.

Happy asset allocating!

Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477.

You should always consult your personal investment advisor/wealth manager before making any decisions.

#allocate #assets #world #rising #interest #rates

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