Interest rates affect investment decisions. The risk free interest rate (assuming the bond is issued by the RBI) can be considered the lowest cost of capital and also the metric by which to measure your return performance. Basically, you’re constantly asking one question — of all the investments you’ve made, have they yielded better returns than risk-free investments?

You should get more returns in proportion to the risk you take. When interest rates fall, this measure of risk-free return also falls, making other investment lines such as stocks, real estate, and private equity relatively more profitable. But now, after a relatively long period of low interest rates, the rate cycle is moving up. A ‘risky’ asset must yield more to be competitive. This changes the dynamics of investing across asset classes.

Bond looks better: Bonds are designed to do well when interest rates start a downward trend and they suffer when rates rise. If you buy a bond in a high interest rate period and sell it in a low interest period, the return on your bond is higher than the interest the bond will pay. This is because when interest rates fall, new bonds issued in the market carry lower interest rates. But you already hold bonds that pay higher interest rates. Because of the higher interest rate attached to your bond, its value (and price) increases. This price appreciation results in a higher return for you. There are times when equities struggle to outperform bonds. The question that will determine how and when bonds get better is — will interest rates stabilize at this point, up or down?

Struggling Equity: Businesses (equities) generally suffer from higher interest rates. If interest rates rise, the cost of capital for the business goes up. This further increases interest costs, lowers profits, and reduces the ability of businesses to invest in growth. The market sees this dynamic clearly. When interest rates rise, equities are revalued and stock prices, especially those of highly indebted companies, are under pressure.

Around 2013, due to lower realized returns (Ebitda per tonne), steel companies were unable to cover the interest costs of the loans they took out. Many steel companies eventually end up in bankruptcy court. These businesses that couldn’t survive 2013 became viable during a period of lower interest rates. Bankrupt steel companies are being acquired by players who can raise new debt at (now) lower interest costs. For example, Tata Steel took over Bhushan Steel, and Arcelor took over many companies. Of course there were other aspects of this corporate takeover, but the ability to service debt, and add new debt, was the main factor.

It’s not all bad; Higher rates are often good for business because they kill weak competitors. Weaker companies find it difficult to pay off existing debt, or add more debt, making them uncompetitive. For example, PSUs will do well in a high interest rate environment because they can raise debt relatively inexpensively, based on quasi-government creditworthiness while their competitors pay a risk premium for the same lines of credit.

Capture the flower cycle: The flower cycle does not change in a hurry. This is a slow and gradual process. Historically, we have seen that high rate cycles don’t last very long and usually reverse within 2-3 years. We are about six months into this cycle. Cues from a changing interest rate cycle will come from inflation trends. When inflation is trending down and the central bank stops raising interest rates, then you know that the cycle has started. There is a strong political angle too – the government may prefer to see growth stall to avoid rising inflation. Therefore, interest rates should last longer than they should.

As usual, the market is hinting at how it thinks inflation will play out. For example, the 10 year yield in the US is already at 4% while the 2 year yield is at 4.5% indicating that the long term yield is lower than the short term yield. This difference in results suggests that the market expects inflation to be lower over the next 10 years but to be higher over the next two years.

Of course, bonds will pay more interest and the benchmark for beating risk-free returns will increase. However, there will always be businesses worth investing in during higher interest rate periods. The lens for viewing opportunity needs to change as we can no longer ride the low interest wave for asset price appreciation.

Deepak Shenoy is the founder & CEO at Capitalmind

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