Investment in debt mutual funds is a popular option for those who want regular income and capital preservation. However, these funds are susceptible to movements in interest rates. As interest rates rise, there is a fall in bond prices, and vice versa.
The inverse relation between interest rates and bond prices is an important aspect to consider when investing in debt mutual funds. In this blog, we will explore the intricate relationship between interest rate changes and the performance of debt mutual funds.
What are Debt Mutual Funds?
Debt mutual funds are investment vehicles that pool money from multiple investors. This money is invested in fixed-income securities such as government bonds, corporate bonds, and money market instruments.
These funds aim to provide capital preservation while delivering stable income at regular intervals, making them an attractive option to risk-averse investors who are looking for investment options with steady returns.
There are different types of debt mutual funds whose maturity profile can range from short-term to long-term. The duration of these funds significantly influences their sensitivity to interest rate changes.
The Relationship Between Interest Rates and Bond Prices
Interest rates, also known as Repo Rate the the cost of borrowing money that banks have to pay to borrow funds from the Reserve Bank of India (RBI). These are influenced by several factors such as inflation, economic growth, and monetary policy.
Any movement in the interest rate whether it’s increasing it to fight inflation or lowering it to stimulate growth, all these changes reflect in the yield of new debt instruments and consequently, the existing ones.
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Interest rates and bond prices are inversely related. As interest rates increase, existing bond prices tend to fall and vice versa. This is because the new bonds are issued at higher yields, and therefore the older bonds that have lower yields become less attractive. As a result, the market value of these existing bonds declines.
For a portfolio that holds the best debt mutual funds, a rise in interest rates can lead to a decrease in the Net Asset Value (NAV) of the fund. In contrast, if interest rates decrease, the NAV can rise, and then existing bonds would become more valuable than the newly issued ones.
Impact of Interest Rate Movements on Debt Mutual Funds
Here is how interest rate changes on debt funds.
Long-term Debt Funds
Long-term debt funds which you see in your mutual fund app invest in securities that have maturities of more than five years, and are more sensitive to interest rate fluctuations.
An increase in interest rates can significantly cause a large drop in NAV, as the prices of long-term bonds decline more sharply.
For example, if a bond’s duration was relatively long like 10 years and interest rates rose by 1%, the bond might see a drop in price by more than 10% depending on its duration. This increased sensitivity makes long-term debt funds riskier during periods of rising rates.
Short-term Debt Funds
In general, short-term debt funds invest in securities that mature in less than three years. Because they have a shorter duration, these funds are less sensitive to interest rate changes.
These funds are less affected by interest rates rising. Whereas, in a declining interest rate environment, short-term debt funds may not be as beneficial as long-term funds would be.
Conclusion
Interest rate movements play a pivotal role in the performance of debt mutual funds. To make informed investment decisions, it is important to understand the relationship between interest rate movements and debt mutual funds. Debt mutual funds are not immune to market fluctuations but do provide stable returns and capital preservation. Understanding how different types of debt funds respond to changes in interest rates can help investors navigate this space efficiently.