Explained: Rising interest rates and investing in debt funds

With interest rates expected to rise, the debt market is uncertain. Investors putting money into mutual funds and other securities are worried about their returns as the Reserve Bank of India prepares to raise interest rates in the coming months to combat the ‘inflation.

Will rising interest rates have an impact on debt funds?

Movements in interest rates influence the performance of debt securities. A rise in rates does not mean that investors will get better returns. On the contrary, the value of debt funds and other instruments falls. When an investor believes that he can obtain a new debt fund with a higher interest rate/coupon rate, he will not opt ​​for existing funds at a lower interest rate or coupon rate.

In contrast, when interest rates fall, the value of the bond or mutual fund increases. This is because the interest rate on old bonds remains high relative to new bonds or funds that are launched.

When the RBI raises key policy rates, bond funds lose their appeal, as new funds with higher coupon rates depress the value of old bonds and funds. The yield on the benchmark 10-year bond fell from 6.91% to 7.19% recently, and prices fell after the RBI hinted at a gradual withdrawal of accommodative monetary policy.

Technically, bond investors will lose when interest rates rise because the net asset value (NAV) of bond funds will decline. NAV is the total value of the debt portfolio divided by the total number of units on a given date. When interest rates rise, the yield or coupon increases but the value decreases, causing the net asset value to fall. The yield or coupon and the value of the bond move in opposite directions.

The net asset of mutual fund schemes under the management of MF Industry was Rs 12.98 lakh crore as of March 31.

What should investors do?

In an environment of high uncertainty, also when inflation is high, it would be prudent for investors to avoid excessive credit and interest rate risk, analysts said. “In our view, a mix of cash-to-cash funds and short-term debt funds, and/or aggressive low credit risk bond funds should remain the core fixed-income allocation,” Pankaj said. Pathak, Fund Manager, Fixed Income, Quantum Mutual. Fund, said.

However, after a sell-off of more than 100 basis points in the bond market over the past year, the return potential of debt funds has improved significantly. However, it will not be smooth sailing as markets will continue to experience bouts of volatility. “We suggest bond fund investors have a longer holding period to weather any intermittent turbulence in the market,” Pathak said.

The way forward for bonds is fraught with uncertainty. Things are still evolving on the geopolitical front and the unraveling of ultra-loose monetary policy has only just begun. “So there will be surprises, there will be misunderstandings and there will be market overreactions. We expect the current phase of market volatility to continue until the market finds its own equilibrium or things calm down on the global front,” he said.

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Will interest rates go up?

Markets expect the RBI to raise the repo rate by 4% during the June or August policy review. “We now expect a rate hike of 25 basis points each in June and August, with a cumulative rate hike of 75 basis points in the cycle. As the spread between bond yields and repo rates increases in a rising interest rate cycle, bond yields could reach 7.75% by September,” said an SBI research report.

The central bank has kept the repo rate unchanged for the past 11 policy revisions in a bid to boost growth. Interest rates on loans and deposits are expected to rise across the board when the repo rate is finally raised in June or August, a banking industry source said.

Both policy rates were last cut in May 2020 with a 4% repo and a 3.35% reverse repo, and have since been held at these historic lows. This situation is likely to change now.

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