Explained: Rising interest rates and debt fund investments

With interest rates set to go up, there is uncertainty in the debt market. Investors who put money in debt 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 tackle inflation.

Will rising interest impact debt funds?

Interest rate movements influence the return on debt instruments. A rise in rates does not mean investors will get better returns. On the contrary, the value of debt funds and other instruments falls. When an investor feels she can get a new debt fund with a higher interest/ coupon rate, she won’t go for existing funds at a lower interest rate or coupon rate.

On the other hand, when interest rates fall, the value of the bond or debt mutual fund rises. The reason is that the interest rate on old bonds remains high when compared to the new bonds or funds that are floated.

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

Technically, debt investors will lose out when interest rates go up, as the net asset value (NAV) of debt funds decline. NAV is the total value of the debt portfolio divided by the total number of units on a particular date. When interest rates rise, the yield or coupon rises but the value declines, bringing down the NAV. Yield or coupon and value of the bond move in opposite directions.

Net assets of debt mutual fund schemes under the management of the MF industry were Rs 12.98 lakh crore as on March 31.

What should investors do?

In an environment of high uncertainty, that too when inflation is elevated, it would be prudent for investors to avoid excessive credit and interest rate risk, analysts said. “In our opinion, a combination of liquid to money market funds and short-term debt…

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