Debt mutual funds and rising interest rates

When it comes to picking debt mutual funds for your portfolio, paying close attention to the interest rate cycle is paramount. If you have just started dabbling with debt fund investments or are planning to do so, understanding the relationship between interest rate fluctuations and debt mutual funds is vital.

For debt fund investors, the interest paid on fund holdings is not the sole income source. Mutual funds majorly invest in bonds that are also traded in the debt market and as is the case with anything traded on a market (for instance equities are traded on a stock exchange) the prices of bonds fluctuate. Now when there is a price increase of a bond, those who have invested in it make additional gains and they can also incur losses when the price of a bond falls but that depends on their coupon payments. If the interest or coupon payment is higher than the fall in the price, it offsets the depreciation.

Now the movements in bond prices are intricately linked to the interest rate cycles in the economy. Bond prices change when the interest rates change or even when a change is anticipated. The Reserve Bank of India pulls the interest rates higher when the economy is teetering on an inflationary phase and slashes interest rate when it is going through a slump. As we discussed in a previous article, bond yields (interest rates) and its prices move in opposite directions.

When interest rates rise, costs incurred by coupon issuers increase as now they would have to pay higher interest rates. To mellow down the impact of the extra costs, they issue more short term bonds because obviously higher interest long term bonds would cost more. This increases the supply of short term paper and investors can choose mutual funds that buy them so that they can reap the benefits of higher interest payments.

In general, debt funds with longer maturity periods are more prone to fluctuations in values due to changes in interest rates than short-term debt funds – the longer is the duration, the higher are the chances of interest rate changes. Hence when interest rates are rising it’s better to invest in short-term debt funds than ones with longer maturity periods.

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