With the long awaited Fed rate decision going through there is finally certainty on the rates front. The Fed rate has been hiked by 25 basis points and there is the possibility of another 100 basis points hike in rates next year. Contrary to expectations, the Indian markets did not react too negatively to the rate hike. But there is room for caution. This was the first rate hike and further rate hikes next year will surely exert pressure on emerging markets including India. It would be interesting to note how this rate hike will impact your mutual funds portfolio.
Impact on the rupee overall…
As domestic investors, why are we worrying about the rupee? Normally, it is only foreign investors who need to convert dollars into rupees and vice versa who should be worrying about the exchange rate. There is actually a strong way in which domestic players and investors also get impacted by the rupee value. Remember, a weakening of the rupee is equivalent to the loss of domestic purchasing power. In a way the depreciation of the rupee is like a higher inflation that is imposed on you. Therefore, a weakening rupee will have the same impact on your portfolio as an increase in inflation has. We all know that higher inflation results in lower real returns. That is exactly the impact a weaker rupee will also have on your portfolio returns. Effectively, if you earn 15% on your mutual fund portfolio and the rupee depreciates by 4%, then in terms of purchasing power your real returns are just 11%.
We all know that higher rates in the US will lead to a strengthening of the dollar. This leads many FIIs to exit their holdings in emerging markets and move towards developed markets. Thus the strong dollar indirectly forces FII selling and the resultant fall in prices results in a fall in your mutual fund NAV. We have seen that post August 2015 the consistent selling by FIIs in equities has kept the mutual fund NAVs under tremendous pressure.
Impact of a strong dollar on short-dollar companies…
So what exactly are short-dollar companies? These are companies that have payables in dollars and are likely to be hit by the weakening of the rupee versus the rupee. Typically, importers and FCCB borrowers are classified as short-dollar companies as they have future payable in dollars. These companies are hit by rupee weakening because in future they will have to shell out more rupees to buy similar quantity of dollars. Typically, companies in the capital goods space and oil marketing space which are major importers are vulnerable to a strong dollar. Additionally, companies with large foreign debt component are also vulnerable to a strong dollar as their liability in rupee terms rises when the dollar strengthens. So what should you do as a mutual fund investor?
You need to closely observe the portfolios of your fund holdings. If your mutual fund holds too much of oil importers, machinery importers or has companies that have a huge foreign debt component like infrastructure and education, then you need to be cautious. You need to shift your mutual fund portfolio in favour of companies that are more of dollar defensives as they will benefit more in this scenario.
Implications for Debt Funds…
A rising yield scenario has never been positive for debt funds. Typically, debt funds hold government and private sector bonds in their portfolio. These bonds typically benefit in a falling rate scenario as the price of the bond appreciates when the rates fall. On the contrary, when yields rise, the bond prices will typically fall. This leads to capital losses in case of bond holdings. This impact is more pronounced in case of long dated bonds, especially the G-Secs that tend to be more susceptible to rate changes.
Within the universe of debt funds, there are certain funds that will benefit from a rising rate scenario. Liquid funds will be largely neutral to rate changes but since they are very short term in nature, reinvestment happens at higher yields. That is important for a liquid low return product. The real beneficiaries will be the floating rate bonds. Typically, floating rate bonds have yields that are linked to the market yields. Hence, you will find the yield of these bonds going up when the market yields go up. Additionally, being floating rate bonds, they do not suffer capital depreciation. Hence in a rising rate scenario, debt fund investors should typically focus on floating rate debt funds.
Impact on equity funds…
For equity funds there is a big valuation question over equities. Let me explain. A rise in bond yields will lead to a collateral rise in the cost of equity. After all, cost of equity uses the bond yield as the base. Since equities are valued by discounting future cash flows backward on cost of equity, this will mean that equity valuations will suffer. This will have a medium term impact on most equity stocks and therefore will also impact the equity mutual fund NAVs.
According to a study done by Russell, the impact of a rate hike on equities is generally short term. In the longer term, a rate hike is seen as a proof that the economy is growing and that is good for equities. Hence in the longer term, a gradual rate hike has been positive for equity mutual funds. That may be the good news for fund-holders.
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