Interest Rate Hikes & Mutual Funds in India

Have you ever wondered why the NAV (Net Asset Value) of a mutual fund might fall even when the bonds it holds are earning interest? One reason for this is a change in interest rates. How do interest rate hikes affect mutual funds in India? To understand this, it is essential to know how the RBI’s interest rate hikes impact bond prices, debt funds, and equity funds and what factors investors should keep in mind.

What Is an Interest Rate? Understand With a Simple Example

An interest rate is the percentage used to determine the interest paid on borrowed money or the interest earned on deposited money. It is important to understand this, as changes in interest rates can also affect the returns on bonds and mutual funds. 

Interest Rate Example

Suppose an individual takes out a loan of Rs. 1,00,000 for one year at an annual interest rate of 8%. If the principal amount remains outstanding for the entire year and simple interest is applied, the calculation would be as follows

This example illustrates that an increase in interest rates can lead to higher costs for a borrower. However, in an actual loan, the calculation of interest and the amount to be paid depend on the terms of the loan.

4 Essential terms for understanding mutual funds

These four rates are interrelated, but they do not change simultaneously or by the same magnitude. For instance, a change in the RBI’s repo rate can impact bond yields and bank interest rates; however, the timing and extent of such an impact depend on market conditions.

Why Does the RBI Increase Interest Rates? 

The Reserve Bank of India (RBI) decides to raise interest rates based on prevailing economic conditions. The primary reasons for this are as follows:

To control inflation

When the prices of everyday goods and services rise consistently, the RBI may increase interest rates, making borrowing more expensive. This helps in curbing spending and demand.

To balance market demand

When individuals and companies begin to spend or borrow at an accelerated pace, demand within the economy can surge. Higher interest rates help to moderate this demand.

To regulate the pace of borrowing

Low-cost credit can encourage individuals and companies to borrow more. Raising interest rates makes taking on new debt more expensive, which can slow down the rate of borrowing.

To manage inflation expectations

If people and businesses anticipate that prices will continue to rise, they may adjust their decisions accordingly. The RBI’s stringent monetary policy helps in keeping these inflationary expectations in check.

To account for global economic conditions

Fluctuations in crude oil prices, foreign interest rates, and the value of the rupee can impact the Indian economy. The RBI takes these global factors into consideration when making its decisions.

How Do Interest Rate Hikes Affect Bond Prices and Debt Mutual Fund NAV? 

When interest rates in the market rise, the prices of previously issued fixed-rate bonds may fall. This is because older bonds can become less attractive when new bonds offer a higher yield. When a debt mutual fund holds such bonds, a decline in their market value can also impact the fund's NAV.

1. Understand the relationship between bond price and interest rate.

Suppose a bond is priced at Rs. 1,000 and it pays Rs. 70 in interest each year.

Calculation of Coupon Rate:

• Coupon Rate = (Annual Interest / Face Value) x 100

• Coupon Rate = (70 / 1,000) x 100

• Coupon Rate = 7%

Now, suppose the price of this bond in the market falls to Rs. 950, while the annual interest remains Rs. 70.

Coupon Yield at Current Price

• = (Annual Interest / Current Market Price) x 100

• = (70 / 950) x 100

• = 7.37% (approximately)

2. How is the NAV of a debt mutual fund affected when bond prices fall?

Suppose a debt mutual fund has a total net asset value (NAV) of Rs. 10 crore. Due to a decline in the market prices of its bonds, the total net asset value decreases by 2%. Assuming all other factors remain constant, the impact would be as follows.

Calculation:

• Value Decline = Initial Net Asset Value x Decline Percentage

• Value Decline = Rs. 10,00,00,000 x 2%

• Value Decline = Rs. 20,00,000

New Net Asset Value

• = Initial Net Asset Value - Value Decline

• = Rs. 10,00,00,000 - Rs. 20,00,000

• = Rs. 9,80,00,000

If the number of units remains the same, the NAV will also see a decline of approximately 2%. This is an example, not a projection of the performance of any actual fund.

3. How to calculate the potential price change using duration?

Modified Duration is used to understand the sensitivity of a bond or debt fund to interest rates.

Formula for a simple Estimate:

• Approximate Price Change (%)

• = - Modified Duration x Change in Yield (%) 

Assume:

• - Modified Duration = 5 years

• - Increase in Market Yield = 0.50 percentage points

Calculation:

Approximate Price Change (%)

= -5 x 0.50%

= -2.50%

If the market value of an investment is Rs. 1,00,000, then the estimated decrease in value will be:

Estimated Value Decline

• = Rs. 1,00,000 x 2.50%

• = Rs. 2,500

Based on this, the estimated market value would be Rs. 97,500, disregarding other factors.

Note: This is an estimate based on Modified Duration. The actual impact on the NAV may differ due to changes in bond prices, yields, credit spreads, or the portfolio itself. A 0.50 percentage point increase in the RBI’s repo rate does not necessarily mean that the yield on every bond will increase by the same amount.

What Is Duration Risk? Calculate the Possible Impact on a Debt Fund 

Duration risk refers to the extent to which the market value of a bond or a debt mutual fund may be affected by changes in interest rates. Generally, a bond portfolio with a higher 'modified duration' is likely to experience greater price volatility in response to a given change in yield.

How to calculate price change using Modified Duration?

Suppose a debt fund has a modified duration of 4 years, and the relevant market yield for its portfolio increases by 0.50 percentage points.

Formula:

• Approximate Price Change (%)

• = - Modified Duration x Change in Yield

• = -4 x 0.50%

• = -2%

If the market value of the portfolio is Rs. 1,00,000, the estimated decline will be:

Estimated Loss = Rs. 1,00,000 x 2%
= Rs. 2,000

Based on this, the estimated market value could be Rs. 98,000, disregarding other factors.

What should one look at to understand duration risk?

These examples are estimates based on Modified Duration and do not represent actual fund returns. The actual impact may differ due to factors such as convexity, interest income, credit spreads, and changes within the portfolio.

Which Debt Mutual Funds Are More Affected by Interest Rate Hikes? 

The impact of rising interest rates is not the same for every debt mutual fund. It primarily depends on the fund's modified duration, the maturity of the bonds, and the securities held within the portfolio.

Do Higher Interest Rates Always Hurt Debt Mutual Fund Returns? 

No, an increase in interest rates is not always detrimental to debt mutual funds. While an initial decline in bond prices may put pressure on the Net Asset Value (NAV), it also creates an opportunity to make new investments at higher yields over time.

Potential pressure on NAV in the short term

When bond yields in the market rise, the prices of existing bonds—which carry lower yields—may fall. This can have a more pronounced impact on the NAV of debt funds that have a higher 'modified duration.' However, the actual effect depends on the specific shifts in market yields and the composition of the fund's portfolio.

Potential for higher interest income from new investments

As existing bonds mature or the fund receives interest payments, the fund manager can reinvest these proceeds at the prevailing, higher market yields. This can lead to better interest income in the future. However, this benefit is not realized immediately, and there is no guarantee that it will occur.

The impact is not the same for every debt fund

What should an investor understand?

• Do not draw conclusions about a fund's performance based solely on a one-day decline in its NAV.

• Examine the fund's modified duration, YTM (Yield to Maturity), and credit quality.

• Understand that a higher YTM indicates potential returns, not a guarantee.

• Consider the suitability of the fund in relation to your investment horizon and when you might need the money.

How Do Interest Rate Hikes Affect Equity, Hybrid and SIP Investments? 

The impact of rising interest rates is not limited to debt mutual funds. It can also affect equity and hybrid funds, though the reasons for this differ.

What is the impact on equity mutual funds?

When interest rates rise, borrowing can become more expensive for companies. This can increase their interest costs and put pressure on their profits. Furthermore, higher interest rates may lead investors to assign a lower value to future earnings, which can result in a decline in the valuation of certain stocks.

What is the impact on hybrid mutual funds?

Hybrid funds invest across different asset classes, such as equity and debt. Consequently, changes in interest rates can affect both components:

• Equity portion: Corporate earnings and stock valuations may be impacted.

• Debt portion: Changes in bond prices can affect the Net Asset Value (NAV).

The overall impact will depend on the fund's asset allocation and its specific portfolio.

What is the impact on SIP investments?

An increase in interest rates does not mean that an investor should immediately stop their SIP. The decision should be based on investment objectives, time horizon, and the type of fund.

• Equity SIPs remain subject to stock market risks.

• Debt fund SIPs remain subject to interest rate and credit-related risks.

• While SIPs encourage regular investing, they do not guarantee returns.

How Can Investors Check Their Mutual Fund's Interest Rate Risk? 

Looking solely at past returns is not enough to understand how changes in interest rates might affect a debt mutual fund. You can gain a better understanding of the associated risks by examining key data points provided in the fund's monthly factsheet.

Check the Modified Duration

Modified Duration indicates how sensitive a bond portfolio's price is to changes in market yields. Generally, a higher Modified Duration means that the portfolio's price is likely to experience greater fluctuations in response to a given change in interest rates.

Check the Yield to Maturity (YTM)

YTM provides an estimated yield based on the current prices of the bonds in the portfolio and their future cash flows. Do not mistake this for a guaranteed return, as actual outcomes may vary due to market conditions, expenses, and changes within the portfolio.

Review Average Maturity and Portfolio Holdings

Average Maturity reflects the weighted average time to maturity of the securities held in the portfolio. Additionally, examine the specific government bonds, corporate bonds, and other debt securities in which the fund invests.

Assess Credit Quality

It is essential to evaluate the credit quality of the entities or companies issuing the bonds. A higher yield does not always signify a better investment; sometimes, it may simply reflect a higher level of credit risk.

How to check a mutual fund portfolio on Rupeezy?

If you use the Rupeezy app, you can search for a specific fund within the 'Mutual Funds' section to view its scheme details. According to Rupeezy’s official support, the platform provides comprehensive fund information, portfolio-related insights, and historical NAV charts.

Common Mistakes to Avoid During Interest Rate Hikes 

During periods of rising interest rates, investors often make hasty decisions. It is important to avoid such mistakes so that investment choices are not based solely on market news.

Assuming every rate hike is bad for the market

While rising interest rates can put pressure on the market, it does not mean that the returns on every stock or mutual fund will decline. The impact depends on prevailing economic conditions and the nature of the investment.

Choosing a fund based solely on past returns

A fund's past performance is no guarantee of future returns. Before investing, one should also consider the fund's objective, portfolio, and associated risks.

Mistaking a high YTM for a guaranteed return

A high Yield to Maturity (YTM) in a debt fund does not mean that an investor will necessarily earn that exact return. Actual returns can be influenced by market fluctuations, credit risk, and fund expenses.

Stopping SIPs without careful consideration

It is not necessary to stop your SIPs simply because the RBI has raised interest rates. First, assess whether there has been any change in your investment objective, time horizon, or the suitability of the fund.

Ignoring taxes and exit loads

Before switching funds or withdrawing money, check the applicable tax rules and exit loads. Hasty changes can negatively impact your actual returns.

Conclusion

Interest rate hikes affect different mutual funds in different ways. In debt funds, bond prices and the Net Asset Value (NAV) can be impacted, while equity funds are affected through changes in corporate earnings and stock valuations. Therefore, do not base your investment decisions solely on the RBI’s rate changes. Instead, make decisions by considering your financial goals, investment horizon, and the risk profile of the fund.

FAQs

Q1. How Do Interest Rate Hikes Affect Mutual Funds in India?

Rising interest rates can put pressure on the NAV of debt funds, while equity funds are affected through the impact on corporate earnings and stock valuations.

Q2. Why Do Debt Mutual Fund NAVs Fall When Interest Rates Rise?

When market yields rise, the prices of existing fixed-rate bonds can fall, which in turn affects the NAV of debt funds.

Q3. Which Debt Mutual Funds Are More Sensitive to Interest Rate Changes?

Generally, long-duration funds are more sensitive because their portfolios consist of bonds with longer maturities.

Q4. Do Higher Interest Rates Always Reduce Debt Mutual Fund Returns?

Not necessarily; while there may be initial pressure on the NAV, new investments made at higher yields can lead to better future interest income.

Q5. How Do Interest Rate Hikes Affect Equity Mutual Funds?

Higher interest rates can increase borrowing costs for companies and put pressure on the valuations of certain stocks.