In the last two credit policies announced in June and August, the Monetary Policy Committee (MPC) hiked the repo rates by 25 basis points each. This has taken the repo rate from 6% to 6.5% in less than 2 months. With the US trajectory still unclear and the RBI also fighting against a weak rupee, this may not exactly be the last of the rate hikes. We all know that any rate hike has serious implications for equity and bond assets. How exactly will they react if the RBI chooses to maintain a hawkish approach to monetary policy.
What happens to debt funds (especially bond funds)
Rate hikes are never great news for bond funds and other debt funds of longer maturity. That is because, bond prices react negatively to interest rates; which means higher interest rates will be accompanied by lower bond prices. That is more so in case of long duration bond funds that are more vulnerable to the fall in price of bonds as a result of rising yields. Debt fund holders could see depreciation in their fund NAVs. This is something that investors in bonds and debt funds need to be cautious about as a series of rate hikes can do considerable damage to the value of your debt portfolio.
Rate hike could hit equity markets via impact on IIP
A rate hike could stall the nascent recovery in the index of industrial production (IIP). Sectors like HCVs, capital goods and even intermediate goods are showing a revival in demand and that could be indicative of a recovery in the capital cycle. At this juncture, any decision by the RBI to hike rates could increase the cost of funds and slowdown the capital cycle recovery. This could be negative for equities from a sentiment perspective and also from the perspective of earnings growth.
Surprisingly, a rate hike will also impact equity valuations.
Why is an interest rate hike by the RBI negative for equity valuations. Let us get back to the traditional DCF (Discounted Cash Flow) method of valuing companies. For starters, you value companies based on projection of future cash flows. Then these cash flows are discounted to present value to arrive at an indicative price for the stock. The future cash flows are discounted back based on the Weighted Average Cost of capital; which is a combination of the cost of equity and the cost of debt. Higher interest rates will increase the cost of debt and therefore the overall cost of capital. When the denominator increases, obviously your present value is going to come under pressure.
Looking at bond yields versus earnings yields and shifting allocations
One also needs to understand the comparison of bond yields versus earnings yields. Bond yield is the interest rate divided by the price. When rates go up the bond yields also go up. This is normally compared to the earnings yield which is the ratio of EPS to stock price. That can also be looked at as the inverse of the P/E ratio. So if the P/E ratio is 20X then the equity yield will be around 5%. If bond yields are up by 200 basis points then it could push up the bond yields and result in a shift of allocations from equity to debt.
RBI will have to do a trade-off between higher rates and weak rupee
There is a currency angle to this entire debate on repo rates. If the RBI chooses not to hike rates the only other option is to let the rupee depreciate. That may not be a very feasible option as India leans heavily on FDI and FPI flows. Both these flows are allergic to a weak currency. While a weak rupee may technically compensate for the rate hikes but it will create a new problem for importers and foreign currency borrowers.
But the whole worry over rate hikes is more in the short term rather than in the medium to long term. A study in the US has proved that if the rate hikes are a reaction to higher inflation and growth, then rate hikes can actually be value accretive or the economic over the next 3-5 years. That is something only time will tell!
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