After raising key policy rate for six consecutive times in the past one year, Reserve Bank of India’s (RBI) monetary policy committee (MPC) pressed a pause button in the latest announcement on Wednesday.
It is vital to note that movement of repo rate triggers a direct impact on the returns of fixed income instruments.
The repo rate hike usually leads to increase in interest rate of fixed income instruments such as fixed deposits (FDs). Conversely, when repo rates are slashed, the FD interest rates also travel southward.
Impact on bond prices
Since interest rates and bond prices share an inverse relationship, bond prices fall when interest rates rise, and vice versa.
This is how it happens: When interest rates rise in the market, the existing bonds offering returns at old rates become relatively less attractive. As a result, investors move from those bonds to the high-yielding instruments. So, the market prices of these bonds fall sufficiently enough for their yields to match those of other instruments.
Let us explain this with the help of an example. Suppose a one-year ₹1,000 bond is sold for 950, its yield would turn out to be 5.26 percent [(1000 – 950)/950 X 100)].
Now, if rates of interest are raised to 9 percent, then bond investors would move to the high yielding instruments to earn 9 percent on their returns, instead of 5.26 percent.
Consequently, the bonds that give a yield of 5.26 percent would decline proportionately to ₹917 so that their yields also rise to match 9 percent.
When bond prices fall to ₹917, investor would stand to earn a yield of 9.05 percent [(1,000-917)/917 X 100)].
Impact on term deposits
Term deposit interest rates move in the same direction as repo rate. This means when repo rates rise, FD interest rates rise. Conversely, when repo rates fall, FD interest rates also fall. The reasoning behind this is simple.
Repo rate is a key policy rate which the banking regulator charges for lending to commercial banks. When repo rate falls, the cost of capital for commercial banks also declines.
It, therefore, incentivises banks to rely less on term deposits for meeting their capital requirement. As a result, FD interest rates also fall in the same proportion.
On the other hand, when repo rates are hiked, cost of capital for banks inch upward. Banks, therefore, raise interest rates on their loans, thus raising their income immediately. As a result, they can afford to offer a higher rate of interest to depositors.
Also, they can meet some of their capital requirement via FDs by offering a higher rate of interest to the depositors since the overall interest rates in the market are high.