Relationship Between Interest Rates and Mutual Funds

Investors know that returns from mutual funds can vary based on market changes and the volatility of securities. However, the country's economic condition also plays a role in determining mutual fund returns. Thus, in a broader context, when interest rates in India change, it also results in mutual funds giving varying returns. How exactly are interest rates and mutual fund returns connected? Let's find out all about that in this blog. 

What are Interest Rates?

Interest rate is the cost at which money is borrowed. It is the base point from which all financial transactions proceed. Interest rates influence consumer spending, business investments, and inflation, making them a crucial tool for controlling economic activity in India.

The RBI determines major rates such as:

• Repo Rate: The rate at which banks borrow money from the RBI.
• Reverse Repo Rate: It is the rate at which the RBI borrows money from banks.
• Cash Reserve Ratio (CRR): The percentage of a bank's total deposits to be kept with the RBI.

These tools help the RBI provide a direction for the control of liquidity, inflation and credit in the Indian economy.

Read More : What is Repo Rate and Reverse Repo?

Why Do Interest Rates Change?

The Indian economy is integrated with the global economy. Whenever the cost of borrowing goes up globally, it will be reflected as an increase in interest rates in India. So, the interest rates change for the following reasons:

• Inflation: High inflation prompts the RBI to increase interest rates to curb excess demand. Conversely, low inflation may lead to rate cuts to encourage spending.
• Fiscal Deficit: A large fiscal deficit often leads to higher government borrowing, which increases interest rates.
• Global Market Trends: Global economic conditions, such as US Federal Reserve policy changes, impact Indian interest rates, especially through foreign capital flows.
• Government Borrowing: When government borrowing rises, it creates upward pressure on interest rates as more funds are drawn out of the financial system.
• Monetary Policy Objectives for RBI: The monetary policy of the RBI aims to balance growth and inflation. Reviews of monetary policies by the RBI also influence interest rates.

Investment – Interest Rate Connection

When interest rates change, the changing borrowing costs impact investments in several ways. At such times, the securities market will face high volatility. Investment decisions and returns differ when interest rates change for the following reasons:

• Borrowing Costs: An increase in interest rates increases the cost of loans (home loans, car loans, personal loans), affecting disposable income. A cut in interest rates reduces EMIs, thus increasing spending power.
• Savings Instruments: Changes in interest rates directly influence the rates of fixed deposits and other saving schemes, such as PPF and NSC.
• Market Sentiment: High interest rates deter investments in the stock market due to more attractive fixed-income alternatives. Lower interest rates are considered more equity-friendly due to decreased costs of raising capital.

How Interest Rates Impact Mutual Fund Investments?

Like any other form of investment, interest rates influence mutual fund investments too. To be able to make the right investment decisions, you must know how this works.

Impact on Debt Mutual Funds

Debt mutual funds are a highly sensitive category to interest rates as such investments are made on fixed-income products like bonds and government securities.

When the RBI raises interest rates, bond prices fall because newly issued bonds offer higher yields, making older bonds less attractive. Conversely, when rates are lowered, bond prices rise due to increased demand for higher-yielding existing bonds.

Debt fund NAVs tend to decline as bond prices fall. Short-duration funds are less impacted than long-duration funds. Similarly, NAVs increase as bond prices rise, benefiting long-duration funds significantly.

Impact on Equity Mutual Funds

Interest rate changes indirectly affect equity mutual funds by influencing corporate profitability and market dynamics. Higher interest rates increase borrowing costs for companies, reducing profitability. Sectors reliant on debt financing, like infrastructure and real estate, are more affected. Lower rates ease borrowing costs, supporting business expansion.

Rising rates can help improve the margins of banks in the short term as lending rates increase. The real estate and infrastructure sectors have to pay more for financing costs during a rate hike, which is likely to dampen growth. Technology and FMCG sectors are less impacted by rate changes and tend to attract investors during high-rate cycles.

Higher interest rates tend to attract FIIs to the debt market, which could lead to outflows from equities. Lower rates work in the reverse direction, promoting foreign investment in Indian equities.

Impact on Hybrid Mutual Funds

Interest rate impacts both equity and debt, making hybrid mutual funds vulnerable to interest rate shocks. A fund manager will reconstitute the portfolio and manage asset allocation to maximise optimal risk-reward balance. For instance, rising rates will increase exposure to short-duration debt and defensive equity sectors.

What Can You Do to Protect Investments When Interest Rates Change?

It is impossible to remove risks altogether with your investments. However, when interest rates change, you can use certain strategies to protect your investments. Some strategies that can help are:

• During Rising Interest Rates: Short-duration and ultra-short-duration debt funds are less affected by rate hikes, as they invest in bonds with shorter maturities. They offer stability and higher returns compared to savings accounts or fixed deposits during rising rates. It may be wise to reduce exposure to real estate and auto sectors when interest rates climb.
• During Falling Interest Rates: Long-duration debt funds benefit from falling interest rates as bond prices increase, leading to higher returns. When interest rates fall, you could consider increasing your investments in the IT and FMCG sectors.
• Asset Allocation: Diversify across equity and debt funds to reduce risk. Short-duration debt funds and defensive equities can protect against rising rates, while long-duration debt and growth-oriented equities can capitalise on falling rates.
• SIPs and Hybrid Funds: SIPs help smooth out market volatility, while hybrid funds offer a balanced approach by investing in both debt and equity, adjusting for changing interest rates.

Conclusion

Interest rate changes made by the RBI impact all types of investments and the return on investments. However, investors have opportunities to maximise returns in both rising and falling interest rate situations. Careful and proactive portfolio monitoring is crucial to ensure that your investment strategy reflects the changes in investment rates. Always remember to keep your portfolio diversified and include SIP investments to smooth out volatility and boost returns.