How interest rates impact mutual funds

There is a strong correlation among asset classes in the investment universe. We explore how the movement of interest rates can affect your mutual fund investment portfolio.

Interest rates impact all aspects of an economy. Multiple variables such as fiscal policies introduced by the government, monetary policies designed by the Reserve Bank of India (RBI), cost of borrowing for other banks (repurchase rate/ repo rate), inflation, currency fluctuations, credit risk (both sovereign and business) influence the rate of interest. Geo-political factors like global trade, oil prices etc, also contribute towards the fluctuations in the interest rate.

Everything we buy or consume also factors the cost of borrowing, and financial products are no different. However, changes in the interest rates have a visible and real impact on an investment portfolio – irrespective of the portfolio being inclined towards equity or debt.

Government and businesses raise capital (issue bonds) by borrowing from fixed-income markets. These bonds are issued in the primary market and are not open for retail or individual investors. However, mutual funds can purchase these bonds and retail investors can gain exposure to such investment tools through mutual funds (secondary market). 

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Valuation of bonds are dependent on three factors: the quality of the instrument (rating), the interest rate and tenure.

While the Net Asset Value (NAV) of debt, money market and liquid funds is driven solely by the valuation, equity funds may have to hold a certain amount in cash/ cash equivalents, or are mandated as per investment objective to limit exposure to equity. This too, has an effect on the rate of interest.

Here’s how changing interest rates affects investor.

Debt Funds

From an investment perspective, the changes in bond prices and yield have an inverse correlation. When the interest rates rise, the bond price dips to balance out the return. Fresh investment in a (cheaper) bond would offer higher yields. Conversely, when interest rates drop, the prices of bonds increase to match the prevailing rate of return in the economic system.

Bond prices and interest rates change in a mathematical and relatively predictable manner and this correlation is visible in the NAV of debt funds.

Over the period, medium and long-term interest rates need to be stable to maintain investor confidence. Every now and then the RBI may intervene to control liquidity (cash in the system), reduce currency volatility, etc. Such interventions can have a positive or negative impact on interest rates.

For short-term debt investments such as money market/liquid funds, arbitrage funds and Fixed Maturity Plans (FMP) higher interest rates may mean a better yield. As the tenure is shorter (usually from one day to one year) the exposure to risk is too limited.

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Investors with a relatively larger risk appetite may look at medium-term investments (three to five years) as they would provide relatively handsome returns at lower risk levels as compared to equity-based investments. 

However, risk-averse investors may seek to invest in instruments with a sovereign guarantee (such as Rural Electrification bonds, Indian Railway Finance Corporation, etc.) which would drain out some investments from the debt fund universe resulting in a drop in corporate bond prices, consequently resulting in a dip in mutual fund NAVs.

On the other hand, if interest rates are too low the real rate of return (post-inflation) would be negligible and investors would seek out better investment avenues.

Equity Funds

Equity valuations too have an inverse correlation with interest rates. With a rise in the interest rates, majority of the risk-averse investors would naturally redirect their capital to a relatively risk-free, fixed return asset class. This has a direct impact on the growth of the stock indices and mutual funds. The mid and small-cap funds get hit the worst.

At the same time, rising interest rate translates to higher cost of borrowing for corporations. This cost is obviously passed on to the consumer, inhibiting the Indian consumers’ willingness to spend and slowing the economy down.

Conversely, if the economy is slowing down, the RBI may reduce repo rate, which will reflect in reduced marginal cost of funds (MCLR) from commercial banks and financial institutions, to fuel growth by reducing cost of borrowing for corporations. It is also done to increase consumer spending, potentially helping businesses post better profits and increase future potential of earning, which directly helps stock prices, hence better returns on Equity funds.

Related: How debt and equity based mutual funds differ in risk 

Conclusion

Balancing the interest rate and liquidity is a constant tight-rope walk for the RBI. Changing interest rates have a clear impact on portfolio yield of both debt and equity funds. Investors need to assess the investment tool based on their own investment horizon and risk appetite. The idea should be to create a diverse portfolio that balances the asset allocation based on risk and return.