What are interest rates in mutual funds?

Have you ever thought about how interest rates affect your mutual fund investments? In this article, we will take a look at what interest rates are, how they impact mutual funds, and how you can navigate these interest rate risks to make informed investment decisions.

• Table of contents

1. Understanding interest rates and why they change
2. Impact of interest rates on mutual funds
3. Ways to navigate interest rate risk in mutual funds

Understanding interest rates and why they change

First of all, let's understand what we mean by interest rates. Interest rates are essentially the cost of borrowing money, typically expressed as a percentage of the loan amount. They represent the additional amount, over the principal, that a borrower needs to pay to the lender. For example, if you borrow Rs. 1,00,000 with an interest rate of 5%, you will need to pay back Rs. 1,05,000, including Rs. 5,000 as interest. Interest rates can be applied to various financial products, such as personal loans, home loans, and even savings accounts. In savings accounts, interest rates represent the earnings you get on your deposited money. Whether you are borrowing or saving, understanding interest rates is important.

Secondly, interest rates change due to various factors:

• Economic growth: When the economy is thriving, there is higher demand for credit as businesses and individuals are more likely to borrow money for expansion. An increase in demand can result in increased interest rates. On the other hand, during economic slowdowns, demand for loans decreases, often resulting in lower interest rates. For example, if many companies are borrowing to build new factories, the overall demand for loans goes up, which can push interest rates higher.
• Inflation: Inflation refers to the general increase in prices of goods and services over time. High inflation reduces the purchasing power of money. To counteract this, central banks may raise interest rates to reduce spending and borrowing, which can help to cool down the economy and control inflation. For example, if inflation rates rise from 2% to 5%, the central bank might increase interest rates to make borrowing more expensive, thereby reducing spending and bringing inflation under control.
• Central bank policies: Central banks, like the Reserve Bank of India (RBI), play a key role in determining interest rates. They use interest rates as a tool to maintain economic stability and control inflation. The central bank may lower interest rates to stimulate the economy by making borrowing cheaper, encouraging investment and spending. On the other hand, they may increase rates to restrict excessive spending and reduce inflationary pressures. For example, during a recession, the central bank might cut interest rates to encourage businesses to invest and consumers to spend more.
• Global economic factors: Interest rates are also influenced by global economic conditions. For example, if major economies like the United States or China experience significant economic changes, it can impact interest rates worldwide. International trade dynamics, geopolitical events, and global financial markets can also play a role.
• Government borrowing: When governments need to borrow large sums of money, it can affect interest rates. If the government issues a lot of bonds to finance its spending, it may drive up interest rates due to increased competition for available funds.

By keeping an eye on economic indicators and central bank announcements, one can anticipate potential changes in interest rates and adjust their financial strategies accordingly.

Impact of Interest Rates on Mutual Funds

Now, you may be wondering how interest rates affect mutual funds. The effect of interest rates on mutual funds can vary based on the type of securities they hold.

• Debt funds: These funds mainly invest in fixed-income securities like bonds. When interest rates rise, the price of existing bonds falls because new bonds are issued at higher rates, making them more attractive. This decline in bond prices leads to lower returns for debt funds. For example, if you hold a bond with a 5% interest rate and new bonds are issued at 6%, the value of your bond will decrease. When interest rates drop, the price of existing bonds increases because they offer higher returns than new bonds. This increase benefits debt funds, leading to higher returns.
• Equity funds: These funds invest in stocks. Higher interest rates can lead to increased borrowing costs for companies, which can reduce their profits. Higher interest rates also make debt instruments more attractive compared to equities, leading to a potential shift of investment from stocks to bonds. As a result, stock prices may decline, affecting the returns of equity funds. However, if the economy continues to grow despite higher rates, companies may still perform well, and equity funds can yield positive returns.
• Hybrid funds: As the name suggests, hybrid funds invest in both stocks and bonds. The performance of hybrid funds depends on how well the stock and bond portions of the portfolio perform in different interest rate environments. When interest rates rise, the bond portion may suffer, but if the equity portion performs well, it can help balance out the overall returns. Similarly, when interest rates fall, the bond portion may perform well, while the equity portion may see mixed results depending on economic conditions. The diversification within hybrid funds can help mitigate the risks associated with interest rate fluctuations.
• Money market funds: These funds invest in short-term debt securities and are highly sensitive to interest rate changes. When interest rates rise, the yields on money market instruments increase, leading to higher returns for these funds. When rates fall, the returns on money market funds decrease. These funds are often considered a relatively stable investment, but their returns are closely tied to the current interest rate environment.

Ways to Navigate Interest Rate Risk in Mutual Funds

Here are some tips to help you navigate interest rate risk in mutual funds:

• Diversify your portfolio: One of the ways to mitigate risk is through diversification. This means spreading your investments across different types of mutual funds, such as equity funds, debt funds, and hybrid funds. By doing this, you reduce the impact of interest rate changes on your overall portfolio. For example, if rising interest rates negatively impact your debt funds, your equity funds might still perform well, balancing out the potential losses.
• Shorter duration debt funds: These funds invest in bonds with shorter maturities, which are less sensitive to interest rate changes. Bonds with shorter durations tend to have less volatility and can provide more stability in a rising interest rate environment. For example, a debt fund that holds bonds maturing in one to three years will generally be less affected by interest rate hikes compared to one that holds long-term bonds.
• Invest via SIPs: SIPs allow you to invest a fixed amount regularly in mutual funds. This approach can help manage risk by spreading your investments over time, reducing the impact of market volatility. When interest rates fluctuate, Systematic Investment Plan (SIP) help average out the cost of your investments, making your portfolio more resilient to sudden changes.
• Consider dynamic bond funds: These funds actively manage the duration of their bond portfolio based on the interest rate outlook. Fund managers in dynamic bond funds can adjust the portfolio to take advantage of interest rate changes, potentially offering better returns in varying rate environments.
• Stay informed: Keeping an eye on economic trends and central bank policies is crucial. Being aware of potential interest rate changes can help you make timely adjustments to your portfolio. For instance, if you anticipate that the central bank will raise interest rates, you might shift some investments from debt funds to equity funds or shorter-duration debt funds. If you're unsure how to navigate interest rate risk, consulting a financial advisor can be useful.

Conclusion

Understanding interest rates in mutual funds is key to making wise investment choices. By knowing how interest rates affect different types of mutual funds and employing strategies to manage interest rate risk, you can better mitigate impact on your investments and potentially enhance your returns. Remember, a diversified portfolio that’s aligned with your risk tolerance and investment goals is your defence against interest rate volatility.

FAQs

How do interest rates influence mutual funds?

Interest rates affect mutual funds differently based on their investment focus. Debt funds are directly impacted by changes in bond prices, while equity funds may see indirect effects through company profits and stock prices.

Do mutual funds go down when interest rates go up?

Not always. While debt funds may suffer when interest rates rise, equity funds and hybrid funds might still perform well if the overall economy remains strong.

Can mutual funds have negative returns?

Yes, mutual funds can have negative returns, especially in volatile market conditions or when interest rates impact their underlying investments unfavourably.

Are mutual fund returns taxable?

Yes, mutual fund returns are taxable. The tax rate depends on the type of fund and the holding period of your investment.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.