A change in interest rates affects the entire economy and financial sector, either directly or indirectly. Everything that we buy, sell or invest in is affected if the national rate of borrowing is changed. Naturally, Mutual funds are also influenced by the changing rates.
As an investor, it is important to understand how this change takes place and what you can do to avoid losses during such times. In this post, we will discuss how interest rates change and what impact it has on Equity and Debt Mutual funds.
Let’s get into it.
What are Interest Rates and why do they change?
Interest rate is the rate of borrowing money set up by the Reserve Bank of India that acts as a base interest for all financial transactions. Since this change is taking place at the top-most level, both bank-to-bank loans and bank-to-customer loans become more expensive.
Every company and individual requires loans in the form of a mortgage, credit card, etc. When the overall cost of borrowing increases, it becomes costlier for both government entities and public companies to function.
This change takes place due to a variety of complex threads that build up our economy like fiscal policy, monetary policy, inflation, demand, and supply curve, etc. Let’s get a detailed view of the key factors that contribute to a change in the interest rates.
The prime factor for a change in interest rates is the demand and supply of funds from lenders and borrowers. Basic economics dictates that when the demand for anything increases, the price goes up.
Thus, when banks get a high number of borrowers, they increase the interest rate so that they can retain enough capital. A high number of borrowers indicate an increased standard of living or economic growth.
A fiscal policy is basically how the government spends its money and finances other operations. In case of fiscal deficit i.e more expenditure than revenue, the government also has to take a loan from the RBI.
Now, when the interest rates are high, the government will take costlier loans making it difficult for individuals and companies to borrow. This leads to what is termed as the “crowding-out” effect. It argues that rising public sector expenditure decreases private sector spending.
The central bank keeps on amending the monetary policy in order to run the economy. A strict monetary policy means the Reserve Bank Of India has a low supply of money and thus it increases the interest rates to balance the production with demand.
A loose monetary policy is when the money supply is high. So the central bank deposits the extra money in local banks. With this excess supply, taking loans became cheaper for the end customer.
The final and most important factor that affects the interest rates is the inflation in the economy. If the flow of money in the economy increases, the value of the denomination will decrease, thus leading to inflation.
This is the reason why Central banks amend their monetary policy from time to time. If the interest rates are very low, inflation will shoot up.
Now that we understand the reason behind the change in interest rates, let’s get into its impact on Mutual Funds.
How do Interest Rates affect Debt Mutual Funds?
Interest rates have a direct impact on debt securities because they are issued by the government. Bonds, for instance, are inversely proportional to the change in interest rates. When the interest rate rises, the old bonds issued at a lower rate decrease in value. This is because a person looking to buy a bond will prefer a higher coupon rate at the same price,
The coupon rate is the periodic payment of interest investors receive on bonds by the issuing party. To motivate investors into buying bonds with lower coupon rates, the price of the bond falls and vice versa.
This is the same effect that a change of interest rate has on debt mutual funds. Taking the same example, Bond funds tend to perform better when the interest rates fall. This is because the already existing securities in the fund’s portfolio likely have higher coupon rates than newly issued bonds and thus rise in value.
On the other hand, if the RBI increases the rate of interest, bonds may suffer a loss as new bonds are likely to bring down the value of old bonds.
How do Interest Rates affect Equity Mutual Funds?
Unlike debt mutual funds, Equity MF has an indirect, but significant impact by a change in interest rate. A high-interest rate means a high cost of borrowing for companies, and this cost is inevitably passed on to the investors in the form of less capital gain, low dividend distribution, etc to cover the borrowing costs.
In such a scenario, a conservative investor shifts his/her money into a more stable asset class.
Alternatively, in an economic slowdown, the central bank may reduce the repo rate that clearly reflects on the marginal cost of funds. This is also done to increase the consumers’ purchasing power.
As a result of this hiked-up purchasing power, corporations are able to generate better returns which means high stock value and thus increased returns from Equity funds.
What should I do to protect my investments?
Change in interest rates is inevitable and not under the control of any individual or company. All we can do is prepare for extreme changes and design a portfolio that is accustomed to the change.
Oftentimes, it is assumed that high-interest rates will negatively impact a portfolio. However, there are ways by which investors can leverage rising interest rates. In an interview with Money Control, the head of fixed income securities in DSP Mutual Fund, Saurabh Bhatia said that it is important to bust the myth that falling interest prices equated to higher risk. It is just a change in phase of the interest rate cycle.
He said that there are three boxes an investor needs to tick off, in order to generate the desired return from MF investments in a scenario of interest rate change, Liquidity, Predictability, and Volatility. Here, liquidity means the ability for investments to adjust according to one cycle of change to the other.
Balancing between debt and equity during a time of interest rate change is one tight rope. A smart investor must balance the two to create a portfolio that can both withstand change and generate high returns