How to rebalance one’s portfolio in a falling interest rate environment

Muneesh, 40, has a large portfolio with major investments in PPF, fixed deposits and equity mutual funds. He still has money lying idle in his savings account, waiting to be deployed. Inflation has been low for some time and the economy needs the stimulus of lower interest rates to spur demand and spending.

There is consensus that interest rates are likely to go lower over the next couple of years. What does this mean for an investor like Muneesh? Does his portfolio need rebalancing, considering these changes in the market environment?

If Muneesh wants to invest surplus funds or renew his existing fixed deposits, there cannot be a better time, because from here on, the interest rates will fall further. He must take advantage of the current high rates and lock into these for a longer period. The same is true for for small savings instruments such as Kisan Vikas Patra, National Savings Certificate, post office deposits and Senior Citizens’ Savings Scheme.

Falling rates increase the demand for older bonds whose coupon rates are higher as they were set in the earlier higher rate market. A higher demand means a higher price. Therefore, holding such bonds may allow Muneesh to benefit from capital gains (or rise in bond prices). Since the bond market is not accessible for retail investors like Muneesh, he could take exposure to such bonds by investing in long-term debt mutual funds, including income or gilt funds, which typically invest in corporate and government bonds. They allow investors to earn capital gains when rates fall.

Interest rate cuts are likely to spur economic activity. Corporate profitability is likely to improve if companies are able to raise funds at lower rates. Revenues may rise if consumer demand improves. So, Muneesh may be better off increasing his exposure to equity mutual funds, especially investing in sectors that gain directly from falling interest rates. Muneesh may be better off splitting his surplus between long-term debt funds and deposits/small saving schemes, in a ratio depending upon his risk appetite. He must also consider increasing his exposure to equity in a gradual manner.

The content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.