If you have recently forayed into the arena of debt fund investments or are planning to do so, then understanding how interest rate fluctuations can impact your debt fund investments is an essential part of the game. While experts are of the opinion that the Reserve Bank of India will refrain from tinkering with interest rates in the future, it can be a good time now for investors to learn the intricacies of the performances of debt funds during different interest rate cycles

Relationship between debt funds and interest rates

Here is a simple breakdown of the correlation between debt funds, interest rates and inflation.

• The Reserve Bank of India hikes interest rates when it senses an influx of inflationary winds when the economy is steadily growing. Similarly, it slashes interest rates when the economy is going through a slump.
• When interest rates go up, the cost of borrowing increases for banks, individuals and customers. Simply put, should you choose to take a loan when interest rates are increasing, you will have to pay a higher interest rate. Obviously when the RBI pulls down the interest rates, loans become cheaper.
• Since debt funds usually invest in bonds and securities that are essentially loans raised by the government, corporations or other entities through investors to finance certain business or economic objectives, changes in interest rates ushered by the RBI has an impact on debt fund investments as well. If prevailing interest rates on loans are going up, the interest on debt funds are also likely to go up. Thus, you will get a higher interest on your investments should you choose to invest in them when interest rates are high.
• An uptick in interest rates will also mean that the value of existing debt instruments may fall. This is because high interest rates may attract more investors to the newer debt funds that pay higher interest. Consequently, older debt funds with lower interest rates may become less attractive to investors. Hence, when investors want to sell older debt funds that pay lower interest rates, they may have to compromise on the price as the investor buying it will want a discount for accepting the lower interest rate.
• The value of a mutual fund investment is determined by its Net Asset Value (NAV). NAV refers to the total market value of a portfolio including any interest or dividends earned, divided by the number of shares outstanding. The NAV varies according to the market value of the fund's assets and so when interest rates rise, the NAV of the debt fund can fall.

Things to know when investing in rising interest cycles

For investors, it is also imperative to factor how the variable time plays. 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.

The higher interest risk is because long-term funds have a greater duration and hence a greater probability that interest rates will vary during its tenure as compared to short or medium-term funds which have a lesser number of interest payments. With shorter–term funds, the chances of drastic movements in interest rates are also lower.

If you want to minimize the risks posed by interest rate fluctuations, then it may be a good idea to invest in short and medium-term debt funds rather than long-term ones when interest rates rise. By adopting this strategy you may able to reap the benefits of high interest rates and the shorter time duration will offset the possibilities of wild variations in interest rates the chances of which increase when the fund is held for a long time.

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