How Interest Rates Affect Mutual Funds

Whenever interest rates are on the lower side, corporations have to spend less on their borrowings which enhances their profitability. This, in turn, increases the returns for mutual funds that invest in those companies. Conversely, when interest rates are high, borrowings become more expensive for corporations which pushes down their profitability. This also decreases the returns for mutual funds that have these corporations in their portfolio.

In the complex world of investing in mutual funds, understanding the relationship between interest rates and mutual funds is extremely important. How interest rates affect mutual funds in India is a separate topic in itself. Interest rates are a key mechanism of the monetary policy of the Reserve Bank of India. Technically referred to as the “repo rate”, they represent the cost of borrowing funds. Knowledge of how interest rates affect mutual funds can help an investor navigate the economic impacts of interest rates and make sound investment decisions. Let us delve deep into changes in interest rates, effect on mutual fund performance, and mitigation strategies for more clarity.

Why do interest rates change?

The Reserve Bank of India uses interest rates as a macro tool for controlling the supply of money in the market and thereby managing inflation. If interest rates are too high, it becomes expensive for corporations to borrow money and they are not able to fund expansion plans and growth. This slows down businesses and causes a dip in the economy. An extreme case of this situation could be one of the reasons for a recession.

On the other hand, lower interest rates imply borrowing money cheaply which causes an influx of credit in the economy. This results in an increase in the prices of goods and services which can finally lead to inflation. Therefore, the RBI has a dual imperative for changing interest rates - spurring economic growth while keeping the inflation within a threshold. Such changes in the interest rates can affect mutual funds in different ways.

Bond prices

1. Bonds

Bonds are debt securities issued by the government or corporate and serve as an instrument of raising money through debt. When an investor or a mutual fund invests in a bond, the money invested is loaned to the issuer of the bond with a promise of a maturity payout and annual interest repayments.

2. Effect of change in bond prices on mutual funds

Debt-oriented mutual funds are impacted due to changes in bond prices. The Net Asset Value (NAV) for a debt mutual fund is based on the market value of the bonds in its portfolio. When the interest rates go up, the market value of bonds issued previously decreases. This is because no investor will buy a bond with a 5% coupon rate when bonds are available at 8% coupon rate. This causes the bond prices to go down resulting in a decrease in the NAV of debt mutual funds. At the other end of the spectrum, the NAV for a debt fund increases whenever interest rates are cut as per the previous logic. This results in capital gains for mutual funds, and in turn, investors.

Also read: What Is Compound Annual Growth Rate (CAGR)

Yield and income

1. During high interest rates

When interest rates rise, new bonds are issued to entice more investors seeking a higher yield. This brings down the value of previous bonds and mutual funds that have allocated a substantial portion of their portfolio towards such bonds see their NAV decline. For investors in such debt-oriented mutual funds, this results in a capital gains loss.

2. During low interest rates

During periods of low interest rates, yield of a newly issued bond goes down. The market places a premium on existing bonds which jacks up their prices. It also increases the NAV of debt mutual funds that hold such bonds. For periods of low interest rates, existing investors of debt mutual funds enjoy capital appreciation on their bond investments.

The nature of bond investments also affect the NAV returns for a mutual fund. Long term debt funds that invest in fixed-rate bonds are more affected by the changes in yield and income than short term debt funds that primarily invest in floating-rate bonds.

Investor behaviour

How interest rates affect mutual funds in India is best understood by the investment and redemption behaviours. Macro environment dynamics induces shifts in investment decision-making. Changes in interest rates are no different and investors shift gears according to the economic climate. These behaviours result in inflows and outflows for a mutual fund. Investor behaviours vary according to the shifts in interest rates.

1. During high interest rates

As soon as the RBI raises the interest rates, investing in bonds becomes less attractive and therefore, existing debt mutual funds see a dip in their NAV returns. Such periods are usually less attractive for equity mutual funds as well. Therefore, investors who have invested in debt and equity mutual funds usually experience a loss. Since the NAVs are typically lower, this period sees more investment than redemption. Therefore, as a part of portfolio rebalancing, a higher percentage of the portfolio is allocated to mutual funds by investors.

2. During low interest rates

When interest rates are cut in order to control the flow of money in the economy, investing in bonds offers lower returns. Therefore, the market places a premium on existing bonds and the NAVs of debt mutual funds rise. Since companies experience a higher profitability, the equity mutual funds also see an upward trend in their NAVs. So, this period sees a lot of redemption for mutual funds rather than investment activity.

A person who has started earning will be more likely to take risks and seek more returns. This goal can be described as ‘wealth maximisation’. Such an investor will invest and redeem across mutual funds as per the changing interest rates. Receiving periodic income is not a priority for such a person, and therefore, he can capitalise on the returns generated from different asset classes through this switching behaviour.

For a retired person, receiving a fixed income is of utmost importance. Such an investor will be risk-averse and his goals would be wealth preservation and fixed income rather than wealth maximisation. He will be less influenced by interest rate fluctuations and prefer staying invested in bonds or other fixed income securities that provide stable income.

Also read: What Is Systematic Withdrawal Plan (SWP)

Performance of the mutual funds

1. Debt mutual funds

Debt mutual funds are directly impacted by the interest rate changes. Whenever the interest rates are cut, bonds become less attractive to investors and the debt mutual funds that have invested in existing bonds see an upward trend in their NAVs. Whereas, for an increase in the interest rates, existing bonds become less preferable and the debt mutual funds that have portfolio allocations in bonds experience a drop in their NAVs.

2. Equity mutual funds

The impact of interest rate changes on equity mutual funds is indirect. For periods of high interest rates, borrowings become expensive for companies which decreases profitability. Also, corporations cannot allocate additional capital for further expansion. So, the net result is that the NAV for an equity mutual fund decreases. On the other hand, companies get to borrow funds at a much cheaper rate during periods of low interest rates which increases their profitability. Additional funds are also borrowed to kickstart future projects. This drives up the NAV for equity mutual funds.

Sector and asset allocation

Fluctuations in the interest rates directly affect the financial sector and capital intensive sectors such as utilities, infrastructure, and manufacturing.

1. Financial sector

Companies in the financial sector bear a loss in interest income during periods of lower interest rates. When the interest rates are high, companies in the financial space have a higher profitability due to a higher interest income. Sectoral mutual funds that invest in financial sectors mimic these changes in the form of higher and lower returns on NAVs.

2. Utilities, infrastructure, and manufacturing

Utilities, infrastructure, and manufacturing are traditionally capital intensive sectors and borrowings are high for regular operations and further growth. This essentially means that for excessive interest rates, these sectors will experience lower profitability but the opposite during a low interest rate environment. This implies that the returns generated by funds investing in these sectors will be dynamic depending upon the prevailing interest rates.

Duration risk

Bonds could be either short-duration bonds or long-duration bonds. Long-duration bonds are more influenced by the interest rate fluctuations because these have longer repayment periods. Therefore, investors have to wait longer to realise their principal amounts. Since new bonds are issued when there is an increase in interest rates, investors shift their allocation to newer bonds and the older long duration bonds become less preferable, leading to a decrease in the bond price. This results in a decrease in NAV for the mutual funds that hold these bonds. Therefore, the mutual funds that invest in long-duration bonds see a more significant impact than those that invest in short-duration bonds.

What can you do to mitigate the effects of interest rates on mutual funds?

Investing is best learned by doing and one of the first rules is to diversify across sectors and asset classes. This refers to allocating the investment across equities, bonds, and fixed deposits in at least 5 different sectors. This allocation must take into account your risk profile, life stage, and financial goals. Allocating 90% of your portfolio to bonds and aiming for higher returns will not make sense. The diversification strategy ensures that you are not overexposed to one asset class or a sector. Investment diversification acts as a hedge against potential downturn in a sector or an asset class and should be your primary mitigation tactic against interest rate fluctuations.

A second tactic is creating an opportunity fund to capitalise on opportunities that arise in the short-term and mid-term. For example, if interest rates are increased, equity mutual funds become less attractive and you should have a corpus to take advantage of lower NAVs. The reverse applies to the case of debt mutual funds.

Also read: What Systematic Transfer Plan (STP)

Different types of mutual funds impacted by interest rates

Generally, debt mutual funds investing in fixed-income securities are impacted the most due to interest rate changes. It is important to note that even within fixed-income securities such as bonds, different types of bonds experience varying levels of impact and the same gets reflected in debt mutual funds. Debt mutual funds that invest in long-duration and fixed-rate bonds are impacted the most whenever the interest rates fall. Debt mutual funds that invest in short-term securities such as money market funds and floating-rate bonds are impacted the least.

Equity mutual funds are indirectly impacted, but the impact is not as severe as in debt mutual funds. Within equity mutual funds, sector-specific funds that invest in infrastructure, manufacturers, and utilities absorb the most impact due to interest rate fluctuation because of higher exposure to debt.

What is the historical relationship between interest rates and mutual fund performance?

Historically, the performance of mutual funds has not just been affected by interest rate changes but also the prevailing economic environment, sectoral exposure, and mutual fund-specific factors. However, general trends indicate that the relationship between interest rates and mutual funds is inverse though the influence is more direct in case of debt mutual funds. Debt mutual funds are more severely affected than equity mutual funds when interest rates are higher. For funds that invest in floating-rate bonds, the effect is slightly muted.

Equity mutual funds have generally performed well when the interest rates are lower as well as in those periods when the interest rates were not excessively high. A moderate interest rate increase does not cause a dip in the economic environment, instead, it generates more economic growth. This leads to higher consumer spending that trickles down to an increase in revenue for companies which boosts the profitability.

Also read: Long Term Capital Gain Tax on Property

Conclusion

How interest rates affect mutual funds in India is a question worth pondering. The answers, though initially appearing to be straightward, can be quite complex if mutual funds are further categorised according to different parameters. An in-depth understanding of the effects of interest rate changes can help you sail through economic volatility. You will be in a better position to estimate the returns for mutual funds as per the prevailing interest rate climate. This will help you make well-informed investment decisions and thereby generate additional returns. You may take the help of a mutual fund advisor who can explain the impact of this macro trend and customise your portfolio according to your financial goals.

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