Why rising interest rates are great for long-term investors

There are hundreds of articles discussing how rising interest rates are bad for investors. They lead to short-term losses and increased volatility for debt investors. Having recently launched a Debt ETF, I would disagree with much content on how rising interests are categorically bad for investors across all groups.

Before discussing the benefits of higher interest rates, let’s understand that there are two types of debt and equity buyers. There are investors, and there are speculators. TV, news, and blogs usually cover speculators’ views, those who are more concerned with quick returns than long-term wealth creation. Higher debt yields may not be good for speculators, but what about long-term investors? Let’s find out.

Higher interest payments: Rising debt yields offer long-term investors a chance to make higher long-term returns than what they currently stand to make in the market. This usually happens via higher coupon payments. Debt that is maturing in the form of an FD/short-term can be re-invested in higher yields, making it better for long-term investors. India tends to be a conservative country, with most of our money locked up in bank savings accounts, FDs and liquid funds. Higher yields will enable the majority of the population to benefit over long-term horizons.

Higher scope of beating inflation: There’s a famous saying - “Money stuck in a bank account will make one poorer over time.” This is because the value of money falls by 3-5 per cent every year (or more) every year due to inflation. In a low-interest-rate scenario - inflation makes one poorer in a much faster way. The biggest enemy for every single investor is not beating the benchmark or even beating FD, it’s beating inflation and low interest rates make the process of beating inflation even harder. Higher interest rates could negate the poor impact of inflation on the value of money.

Less risk-taking behaviour: With low-interest rates - investors tend to take higher risks in their portfolio. We have already seen the poor effects of mutual companies taking excessive risks in credit risk funds in 2020.

With liquid funds delivering sub 4 per cent returns, I see many investors who used to be conservative are now investing in high-risk corporate bonds. Some investors are also switching their debt portfolios to equity, changing their asset allocation to match their return needs instead of the risk profile.

High interest rate chasing usually leads to long damage to the portfolio. We have seen this in the US, where the 60/40 equity/debt portfolio is essentially worthless as interest rates drop to 0 per cent. Many investors are now taking excessive risk investing in equity and high-risk bonds. With rising interests - investors will be less incentivised to take higher risk.

Less debt in the system: There are rich people, people who are broke, and then those in debt. The ones in debt with no stable income are in the worst category. Low-interest rates incentivise companies and people to take on excessive debt, which is usually bad. Coming back to the US - credit cards and low rates have spoilt corporates as well as people. Higher rates dis-incentivise debt taking and, therefore, good for the system overall.

Better for asset allocation: Asset allocation is the gold standard in investment management today. Conservative investors or investors who are old have all or most of their investments in debt products. Low-interest rates usually hurt them the most over long-periods. The typical US investor - 60/40 portfolio is looking bleak with 40 per cent of the debt portfolio sitting at 0 per cent. Hence higher interest rates are better for a more balanced portfolio.

What about stocks? Yes, a rising interest rate scenario is probably not great for stocks, but
that’s for a short-term investor. In the long-run, stocks are slaves of corporate earnings, not
interest rates. In conclusion - If you’re worried about the short-term losses in your debt fund, then remember, you’re a speculator, not an investor.