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Repo rates are rising - what should investors do?

Posted on 06 Jul 2022 • Updated on: 08 Feb 2023
Author: Sayan Sircar

Tags: Portfolio Construction

12 mins read
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This article explains how the RBI repo rate drives the values of all your loans and investments and shows what investors should do to best take advantage of the situation.

Repo rates are rising - what should investors do?

News on the repo rate

RBI, in line with other central banks, has hiked the Repo rate from 4.00% to 6.50% in quick succession:

06-Apr-2023 to 08-Feb-2024: RBI kept the repo rate unchanged at 6.50%.
08-Feb-2023: RBI hiked the repo rate to 6.50% from 6.25%.
07-Dec-2022: RBI hiked the repo rate to 6.25% from 5.90%.
30-Sep-2022: RBI hiked the repo rate to 5.90% from 5.40%.
05-Aug-2022: RBI hiked the repo rate to 5.40% from 4.90%.
08-Jun-2022: RBI hiked the repo rate to 4.90% from 4.40%.
04-May-2022: RBI hiked the repo rate to 4.40% from 4.00%.

The hike is a part of inflation-taming measures put in place by global central banks. For RBI, the Repo rate is now rising towards the pre-COVID-19 pandemic days when the rate was 5.15%. It was lowered twice in March 2020 (to 4.40%) and then again in May 2020 (to 4.00%) to negate the impact of the economic slowdown caused by the pandemic.

As inflation has been rising as the economy recovered, the repo rate rise was inevitable, and further rate increases are unavoidable. The RBI is planning more rate hikes.

Understanding the Repo Rate

Repo rate is the rate of interest RBI, the country’s central bank, charges all other banks when borrowing from RBI. The higher the repo rate, the more banks have to pay RBI when borrowing. As a result, the bank charges higher interest rates to people who borrow. The bank offers higher rates for depositors in savings accounts and fixed deposits.

The repo rate, therefore, directly impacts

savings account, fixed deposit and recurring deposit rates
borrowing rates for personal, gold, car, home and other loans
rates of loans that are given to businesses

The basic interest rate equation for a loan is:

Rates for loans = Base rate + Spread

The base rate is derived from the RBI Repo rate. The spread depends on the loan type and the borrower’s credit quality. For example, home loans have a lower spread since they are collateralised. In contrast, personal loans, being without collateral, have a higher spread.

The repo rate, and its counterpart, the reverse repo rate, which RBI offers to banks for depositing money with RBI, are crucial monetary policy tools that affect liquidity and inflation. The higher the repo rate, the higher the loan rates and the more difficult it is to borrow. The lower the amount of borrowing, the less the money supply since borrowers spend their loans for their purpose. Less spending by borrowers or depositors, who are attracted by higher deposit rates, the lesser the amount of money available in the economy, thereby cooling inflation.

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Repo rate history

The chart below shows the history of the RBI repo rate over time:

Chart: Arthgyaan • Source: RBI • Get the data

Impact on loans

A home loan rate is amongst the cheapest loans available. Still, given their size, a substantial part of the monthly budget of borrowers goes to the home loan EMI. Hence we will discuss the impact of repo rate changes using the example of a home loan rate.

We break down the home loan rate into its major components to see where the fluctuations come from:

Repo linked Home loan rate = Repo Rate + Spread + Premium

Repo rate: Home loan rates will move up and down as soon as RBI revises the Repo rate.

Spread: This is an additional rate on top of the repo rate that essentially captures the profit the bank can make off this loan relative to the deposits it offers to customers. This rate is generally revised every three years but will vary from bank to bank.

Premium: an extra value for some specific customers. E.g. SBI adds another 15bps for non-salaried customers or will depend on the CIBIL or credit score. This value is also revised periodically, like every three years.

Quick calculator for checking your EMI

Please use the sliders below:

Impact on deposits

As the repo rate rises, the economy’s overall interest rates increase. Banks raise deposit rates if you follow the news, the FD rates have already followed the repo hikes. If you want to invest in FDs, consider the tax impact and the upcoming rate hikes.

We have already covered the tax impact of FDs vs debt mutual funds here: Mutual Fund vs Fixed Deposit - where should you invest?.

If rates are expected to rise for fixed deposits, it will be more prudent to create an FD ladder instead of one large FD. The easiest way to create a ladder is to split the amount into, say, four equal parts and make 4 FDs maturing 6-12 months from each other. This way, the first FD maturing can be rolled over at the new higher rate when rates go up.

Impact on Government schemes

Small savings schemes include post office deposits, Monthly Income Account Scheme (MIS), Senior Citizen Savings Scheme (SCSS), National Savings Certificate (NSC), Public Provident Fund (PPF) scheme, Kisan Vikas Patra (KVP), and Sukanya Samriddhi Account (SSA) Scheme.

Rates updated on 08-Mar-2024

Instrument	Rates of interest from 01-Mar-2024 to 30-Jun-2024
Saving Deposit	4.0%
1 Year Time Deposit	6.9%
2 Year Time Deposit	7.0%
3 Year Time Deposit	7.1%
5 Year Time Deposit	7.5%
5 Year Recurring Deposit	6.7%
Senior Citizen Savings Scheme (SCSS)	8.2%
Monthly Income Account Scheme (MIS)	7.4%
National Savings Certificate (NSC)	7.7%
Public Provident Fund (PPF) scheme	7.1%
Kisan Vikas Patra (KVP)	7.5% (will mature in 115 months)
Sukanya Samriddhi Account (SSA) Scheme	8.2%

Source:: https://dea.gov.in/budgetdivision/interest-rates

Small savings schemes like PPF, Sukanya Samriddhi, Post Office deposits, KVP and NSC indirectly relate to the RBI repo rate. For example, PPF rates are typically due for revision every quarter. So they might follow the repo rate hikes along with the other small saving schemes. Investors in RBI Floating Rate Savings Bonds 2020 should expect a hike in interest rates as well since these bonds pay out an interest pegged to the NSC rate plus a spread of 0.35%.

Investors should carefully evaluate if the new rates make these small savings schemes more desirable for their long-term goals.

Impact on bonds and debt mutual funds

Bond yields, for both government and corporate bonds, move up and down with changes in the repo rate. This is because older bonds before the hike offer lower interest rates and are less desirable than newer bonds issued with higher coupons. This phenomenon is the reason that bond prices fall when rates rise.

As a direct result, debt mutual fund NAVs also decrease similarly. The higher the maturity of the bonds in the fund’s portfolio, the higher the fall. On the other hand, shorter maturity debt funds, like liquid and money market categories, fall least since their duration is low while simultaneously closely following the rise in the yield curve, thereby giving higher and higher returns.

We have discussed this feature of debt funds extensively here: Should you match debt portfolio duration with goal duration?.

Impact on equity mutual funds

We will briefly cover a rate hike’s impact on equity markets. First, higher interest rates make it more expensive for companies to borrow money. This increases the cost of capital higher, leading to a lower stock valuation. For those in the know, this is the phenomenon of increasing the firm’s Weighted average cost of capital (WACC), which reduces the stock price arrived via a DCF valuation method.

Also, stock markets have been falling since October 2021 due to high inflation. High inflation levels make different companies react differently since customers prioritise their purchases based on what they need (mandatory goods) while cutting down on discretionary items. As a result, the overall interplay is fairly complex regarding the effect on the stock market and, therefore, on equity mutual funds.

Investors should understand how to invest in such a market where both stocks and bonds are falling via this article: What should you do when both stocks and bonds fall?

What should investors do?

We will cover the next steps suitable for accumulation-stage investors who have not reached their retirement age.

Manage their budget by smartly paying off loans

If you have multiple loans, pay off the highest rate loans as soon as possible: Which debt to pay off when you have more than one loan?.

If you have a home loan, consider prepayment or start building an EMI buffer fund. If you are planning to take a home loan, understand how a loan like a home loan changes your entire risk profile.

You should also check that your emergency fund covers 6-12 months of EMI at the new higher rates.

Keep investing in equities

A fall in equity markets is an opportunity that you should exploit as best as possible. First and foremost, do not stop investing. Then, review your investment plan and rebalance from debt to equity opportunistically.

Stick to short-maturity debt funds

Low-duration debt funds in a rising interest rate regime closely follow the yield curve. This basically means that as new bonds are issued continuously, the fund buys into them as older short-duration bonds mature. This pushes up the portfolio yield quickly and does not require much time to recover from the fall due to rate hikes. This is a guide to choosing debt mutual funds that you will find helpful.

Focus on their human capital

You need money to make money.

Human capital is an estimate of the future earning potential of an investor, either from salary, profession or business. As age increases, human capital will reduce; however, the investments made by the investor create a portfolio, i.e. financial capital that meets all financial goals.

Focusing on improving your earnings potential by, for example, upskilling at your job will increase your future corpus simply because you are investing more. This article discusses the concept in more detail: Your human capital, not investment returns, is your biggest wealth creator.

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