Impact of Interest Rate on Mutual Funds and Stock Investment

Interest rates have a large impact on investments in mutual funds and stocks. Changes in interest rates influence the performance of bonds, stocks, and other assets. Understanding the relationship between interest rate changes and investment performance can help investors make wiser choices.

• Table of contents

• Why do interest rates change?
• Things to do to mitigate the effects of interest rates on mutual funds
• How different funds are impacted
• Historical relationship

Why do interest rates change?

Central banks increase or decrease interest rates to manage economic growth. Lower rates encourage borrowing and spending to stimulate the economy. Higher rates discourage borrowing to prevent inflation.

Interest rates fall when economic growth is sluggish. Rates rise when growth is strong, or when inflation is increasing. The Reserve Bank of India raises or lowers its repo rate which impacts other interest rates.

Bond prices

Bond prices are inversely related to interest rates. When interest rates rise, bond prices fall. When rates fall, bond prices increase.

This happens because bonds pay fixed interest rates. New bonds pay higher rates when issued at higher prevailing rates. Old bonds with lower rates are less attractive, so their prices fall to make it more attractive to investors.

Yield and income

Rising rates mean new bonds offer higher yields. This gives investors incentive to sell old lower-yielding bonds, driving their prices down.

Bond funds with lower-rate bonds will see a fall in NAV’s as well as total returns in a rising rate environment. Bond fund income or yield will increase with higher rates.

Investor behaviour

When interest rates rise quickly, bond investors tend to sell bonds rapidly. This supply of bonds for sale drives prices down further. Some investors may panic and sell quality bonds at temporarily reduced prices. Other investors may see value and buy bonds at lower prices. Disciplined investors can benefit from market overreactions to interest rate changes.

Interest rates and the stock market

Rising interest rates can negatively impact stock prices. Higher rates mean bonds become more attractive versus stocks. Investors requiring regular income may sell stocks and buy newly issued bonds at higher yields.

However, stocks can still perform well during periods of rising rates. Strong corporate profits and earnings growth can offset pressure from higher bond yields.

Performance of mutual funds

Bond funds perform poorly when rates rise, while money market and short-term bond funds hold value better as they have less interest rate sensitivity due to their shorter durations. Income funds may see higher income due to rising rates, but their total return could be lower because of the decline in bond prices.

Some stock funds can generate positive returns in rising rate environments. Funds focused on growth stocks often outperform value stock funds. Higher rates tend to benefit financial sector stock funds as these companies may see improved profit margins and growth opportunities.

Sector and asset allocation

When rates rise, mutual fund managers often reduce portfolio duration by selling long-term bonds and buying shorter-term bonds. Adjusting allocation to different bond sectors and maturities can mitigate risk.

Increasing stock allocation can offset poor bond fund performance during periods of rising interest rates. Fund managers may shift assets from bonds to stocks systematically as rates increase.

Also Read: What Are Interest Rates In Mutual Funds?

Things to do to mitigate the effects of interest rates on mutual funds

• Review current mutual fund holdings - Identify which funds are most vulnerable to rising rates, like long-term bond funds. Also look for funds likely to outperform like short-term bond and floating rate funds.
• Rebalance your portfolio - Rebalance to target allocations. Trim overweighted bond funds and allocate more to equity funds positioned to do well when rates rise.
• Add short-term bond funds - Increase exposure to short-term bond funds holding bonds maturing in 1-3 years. Their prices will be more stable as rates rise.
• Evaluate floating rate funds - Consider adding senior loan or bank loan mutual funds. Their variable rate investments pay more income as rates increase.
• Seek growth stock funds - Growth stocks can still perform well in rising rate environments. Choose active stock funds focused on growth sectors.

How different funds are impacted

Long-term bond funds and long-term government bond funds tend to be hit hardest when interest rates increase. These funds invest primarily in bonds with maturities over 10 years. As rates rise, prices of long-term bonds fall more sharply compared to short-term bonds. This leads to greater price declines for the long-term bond funds.

Intermediate-term bond funds hold up relatively better, as they invest in bonds with shorter 5-10 year maturities. These bonds see smaller price drops when rates rise. Total returns decline less for intermediate bond funds.

Short-term bond funds and ultra short-term bond funds see the lowest impact, as they invest in bonds maturing in 1-3 years. The prices of these shorter-term bonds are more stable when interest rates rise. Total potential returns may even stay positive for some short-term bond funds.

Floating rate funds and bank loan funds can sometimes benefit from rising interest rates. These funds invest in variable rate debt that pays higher income as rates increase. Their prices are less sensitive to rate changes.

When it comes to stock funds, growth stock funds and cyclical sector funds tend to outperform defensive stock funds and value funds when rates are rising.

Growth stock funds invest in stocks with rapidly rising earnings. These stocks can still do well in higher rate environments. Cyclical sector funds focused on areas like financials and industrials also typically excel as rising rates indicate economic strength.

In contrast, defensive stock funds invested in low-volatility consumer staples, utilities, and real estate tend to underperform. Their dividend yields look less attractive compared to rising bond yields. The same is true for value stock funds.

Historical relationship

Examining history shows rising rate environments are associated with bond price declines and flat or volatile stock market returns. But other factors like economic and profit growth also impact performance. Some rising rate periods have strong stock returns, while others see flat or negative returns. Predicting exactly how rising rates will impact markets is difficult. Flexibility and diversification are key.

Also Read: How Mutual Fund NAV Per-Unit Is Determined

Conclusion

Changes in interest rates significantly influence mutual fund and stock market performance. Investors should understand how their funds may react to rate shifts. Adjusting asset allocation and being selective within fund categories can help manage interest rate impact.

FAQs:

Which mutual fund is suitable when interest rates rise?

Short-term bond funds and floating rate funds often outperform long-term bond funds when rates are rising. Certain growth stock funds can also do well in rising rate environments.

How does interest and inflation affect mutual funds?

Rising inflation drives interest rates higher. This causes bond mutual funds to lose value. But stock funds focused on commodity producers and other inflation beneficiaries can outperform.

What happens to debt mutual funds when interest rates rise?

Debt mutual funds invested in bonds will see lower total returns. Long-term bond funds suffer the largest price declines. Short-term bond funds hold up better but still lose some value.

What happens to investment if interest rate increases?

Bonds and bond funds lose value when rates rise. Stock markets typically become more volatile with increased uncertainty. But stocks can still gain if corporate profits remain strong.

Are mutual funds affected by interest rates?

Yes, interest rate changes significantly impact performance of bond mutual funds. Even stock funds are affected, though to a lesser degree than bond funds. Rising rates favour some stock fund sectors over others.