What Is The Impact Of RBI Rate Hikes On Debt Mutual Fund Investors

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Impact of RBI Rate Hikes on Debt Mutual Fund Investments

Are your funds invested in debt mutual funds? If so, recent changes by RBI might be of huge concern to you.

Historically, debt mutual funds have been seen as a safe bet, often offering solid returns. But here's a twist. Over the past year, the repo rate has been on a consistent upward trajectory. Just to give you a perspective:

  • May 2022: 4.40%
  • June 2022: 4.90%
  • August 2022: 5.40%

Now, it stands at a striking 6.50%, with the reverse repo rate at 3.35%.

Wondering why these rates matter? Changes in these rates directly influence debt, which can have ripple effects on your investments in debt mutual funds.

It's essential to understand what this means for you and your hard-earned money.

Before jumping to conclusions, let's first clear up some basics. Dive deeper into understanding the implications of these rates on your investments and how to best navigate this changing landscape.

What's the Repo Rate?

One of the most important phenomena in the banking sector is the repo rate. It is the interest rate at which the RBI lends funds to banks in the country.

If we put it in simple terms, the higher the repo rate, the more costly it would become for the bank to borrow funds, and the less the inflation in the country. This affects both commercial lending and deposit rates.

Let's look at the different tools of monetary policy that are maintained by RBI other than the repo rate: 

Reverse Repo RateIt is the exact opposite of the repo rate as the RBI seeks loans from commercial banks at this rate. It is generally lower than the repo rate. 
Cash reserve ratioIt is the proportion of a bank’s total deposits that it must maintain as reserves with the RBI. It is done to control inflation in the economy as well as manage liquidity in the banking system.
Statutory Liquidity Ratio This is the ratio that requires banks to maintain a certain percentage of their net demand and time liabilities in the form of liquid assets. It is to keep the liquidity of the bank under check. 
Marginal Standing Facility (MSF) RateIt is the rate at which RBI lends money to commercial banks on an overnight basis. It is generally higher than the repo rate. 
Standing Deposit Facility (SDF) RateIt is the exact opposite of the Marginal Standing Facility Rate as this is the interest rate offered by the RBI to banks on their overnight deposits with the central bank.

The Immediate Impact On Debt Mutual Funds

The repo rate directly influences inflation in the country. But what is its immediate effect on debt mutual funds?

Repo Rate and Debt Mutual Funds' NAV

It's a common perception that an increase in repo rates adversely affects debt mutual funds by decreasing their Net Asset Value (NAV).

To understand this, let's define NAV: It's the net value of an investment fund's assets minus its liabilities, divided by the number of outstanding shares. A decrease in NAV implies potential losses for investors.

Illustrating with an Example

Imagine a debt mutual fund issued at a face value of INR 100 with a coupon rate of 9%, implying a yield of 9%. When the Reserve Bank of India (RBI) hikes the repo rate, lending rates tend to increase in tandem.

Consequently, newer debt mutual funds might be offered at elevated coupon rates, like 11%. This increment makes the previously issued bond, which yielded returns at 9%, less appealing, causing its value to drop.

The Silver Lining for Debt Mutual Fund Investors

An increase in the repo rate doesn't spell perpetual doom for existing debt mutual funds. It's pivotal to remember that market conditions oscillate. An unwavering belief in your investments is key. Quality funds are poised to deliver commendable results over time, especially once repo rates stabilize.

A Few Key Terms To Know About Debt Funds

No matter if you're investing in debt mutual funds or debt stocks, there are a few terms that you need to know about already. This is to make sure that you don't face confusion later on when you kick off your debt mutual fund investment journey.

Coupon rateIt is the annual interest rate which is paid by the issuer of the bond. This interest is paid out annually, semi-annually and quarterly. If a bond doesn't have to pay any interest, it is called a zero-coupon bond.
Yield Unlike coupon rates, yield is not fixed. It keeps on changing with the fluctuations in the market. Therefore, the price of the bond will be required to be kept according to the interest changes so that a particular yield can be induced. 
Yield To Maturity This is the rate of interest that can be expected by an investor if he keeps the security in his portfolio until its maturity. In case the YTM of a particular security is 12%, it will give you a yield of 12% at maturity if the market conditions remain constant for the security.
Weighted Average Maturity The average time taken by securities in the portfolio to mature, weighted in proportion to the amount invested, is referred to as weighted average maturity. The maturity period will also depend upon the sensitivity of the portfolio to interest rate changes. 
Modified DurationIf you need to understand a bond's sensitivity to changes in interest rates, modified duration is going to be helpful. So if we put it simply, it is the change in the value of a bond in response to the change in the interest rates. 

What To Do As A Debt Mutual Fund Investor?

1. Short Term Investors

If you have invested in a mutual fund that has a duration of a couple of months or a year, it will be very well suited for riding interest rates. It's because you have invested into a fund that's having a less maturity period. Thereafter, you can invest in another debt mutual fund that is coming with a higher coupon rate offering.

Debt funds can be opted for short to medium terms as well. So when there's a hike in the rates by RBI, you won't be too concerned about your investments. Therefore, one can stick to shorter-duration investments to eventually get the benefit of rising rates.

Let’s suppose you are a short-term investor who needs money in 6 months to fund your child's education. You could invest in a liquid fund, which has a duration of 1-3 months. Liquid funds invest in money market instruments such as treasury bills and commercial papers, which are very liquid and can be easily redeemed.

2. Long Term Investors

If you invest in normal debt funds or bonds, you might suffer from losses due to the rise in rates by the RBI. But things work a little differently when it comes to debt mutual funds.

Generally, the pool manager invests funds in bonds and securities whose maturity is in line with the fair market price.

The transparency of the returns and maturity date of the debt mutual funds should be enough for you to feel safe about investing your money in them, even if the interest rates are high. Moreover, these funds have the potential to eliminate duration risk linked to changing interest rates.

Now let's suppose if you are a long-term investor who is looking to generate income and preserve your capital, you could invest in a gilt fund, which invests in government bonds. Government bonds are considered to be very safe investments, and they offer a fixed income stream.

Disclaimer: This is just for education purposes and you should know that investments in debt mutual funds are subject to market risks. Please read the scheme-related documents carefully before investing.

Final Analysis

As you know, the debt or equity market keeps swinging like a pendulum. The most important thing here is to show faith in your investments and trust them for the long run.

There's no doubt that the rise in rates by the RBI will initially be a bad situation for the debt mutual fund investors. But this situation is generally fickle and the market stabilizes after a point.

So, as a debt mutual fund investor, you have to focus on the following things:

  • You shouldn't panic. If you believe in the debt mutual fund, the overnight changes in RBI rates shouldn't change your opinion about it. 
  • Do not let the fear of rising interest rates keep you from investing in debt funds

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