Explained: Rising interest rates and debt fund investments

On the other hand, when interest rates fall, the value of the bond or debt mutual fund rises. The reason is that the interest rate on old bonds remains high when compared to the new bonds or funds that are floated.

When the RBI hikes the main policy rates, bond funds lose their appeal as new funds with higher coupon rates push down the value of old bonds and funds. The yield on 10-year benchmark bonds rose to 7.19 % recently from 6.91%, and prices declined after the RBI hinted at a gradual withdrawal of the accommodative monetary policy.

Technically, debt investors will lose out when interest rates go up, as the net asset value (NAV) of debt funds decline. NAV is the total value of the debt portfolio divided by the total number of units on a particular date. When interest rates rise, the yield or coupon rises but the value declines, bringing down the NAV. Yield or coupon and value of the bond move in opposite directions.

Net assets of debt mutual fund schemes under the management of the MF industry were Rs 12.98 lakh crore as on March 31.

What should investors do?

In an environment of high uncertainty, that too when inflation is elevated, it would be prudent for investors to avoid excessive credit and interest rate risk, analysts said. “In our opinion, a combination of liquid to money market funds and short-term debt funds, and/ or dynamic bond funds with low credit risks should remain the core fixed income allocation,” Pankaj Pathak, Fund Manager, Fixed Income, Quantum Mutual Fund, said.

However, after a more than 100-bps sell-off in the bond market over the last year, the return potential of debt funds has improved significantly. However, it will not be a smooth ride as markets will continue to have bouts of volatility. “We suggest bond fund investors to have a longer holding period to ride through any intermittent turbulence in the market,” Pathak said.

The path forward for bonds is filled with uncertainty. Things are still evolving on the geopolitical front and the unwinding of the ultra-easy monetary policy has only just begun. “So there will be surprises, there will be miscommunication, and there will be market overreactions. We expect the current phase of market volatility to continue until the market finds its own balance or things settle down on the global front,” he said.

Will interest rates go up?

Markets expect the RBI to increase the repo rate from 4% in the June or August policy review. “We now expect a 25-bps rate hike each in June and August, with a cumulative rate hike of 75 basis points in the cycle. Given that the spread between bond yields and repo rate jumps in an increasing interest rate cycle, bond yields could touch 7.75 per cent by September,” a research report from SBI said.

The central bank has kept the repo rate unchanged in the last 11 policy reviews in a bid to boost growth. Interest rates on loans and deposits are expected to rise across the board when the repo rate is finally hiked in June or August, a banking industry source said.

Both policy rates were last reduced in May 2020 with repo at 4% and reverse repo at 3.35%, and have since been kept at these historic lows. This situation is likely to change now.