There has been a buzz all around about the RBI repo rates recently, throwing markets and investors into a tizzy. RBI had considerably reduced repo rates in pandemic times to revive a slumped economy. Having been stagnant at 4.00% for 2 years, the RBI recently increased this, first to 4.40% in May 2022, then to 4.90% in June 2022 & then most recently to 5.40% in August 2022*. In fact, it is expected that this can be increased further by RBI in its upcoming monetary policy releases.

*Source: https://housing.com/news/rbi-monetary-policy-interest-rates/; As on August 5, 2022.

Changing interest rates tend to directly impact debt, making debt fund investors worried and concerned over what impact this will have on their investments? But is there really cause for worry or is there a more prudent way for debt fund investors to handle this hike?

First things first, what is this repo rate?

Repo rate is the interest rate at which the RBI lends funds to banks in the country, against pledge of their government securities. Simply put, the higher the repo rate the costlier it becomes for banks to borrow funds. This effects both commercial lending and deposit rates. Lending rates too rise to support increased repo rate, whereas deposit rates rise so that banks can attract more funds from the investing public.

Impact on debt mutual funds – the immediate impact

It is widely believed that increased repo rates adversely effects debt mutual funds by reducing their NAVs. How so? Due to the basic rule that when interest rates rise, prices of debt instruments fall.

Consider this simple example:

Let’s say an RBI bond investment is issued at a face value INR 100 has a coupon rate of 7%, this would make its yield to 7% (7/100). Now when repo rates rise, so do lending rates; so, let’s say a new bond issue is offered at a higher coupon rate of 9% (yield 9%).

This will lower the demand for earlier bonds series whose yield is 7%. Thereby reducing the price of the bonds!

In fact, this very risk of price variations of debt instruments is termed as duration/interest risk.

But is this all?

While theoretically this may be true, there is more to the relationship between repo rate and debt mutual funds than what meets the eye.

This tends to be the immediate impact. But investing is more about vision and the future than merely immediate changes and reactions.

What can you do if you are a debt fund investor?

For short term investors – one can stick to shorter duration investments to eventually get benefit of rising rates

Short term funds that have a duration of a few months to a couple of years can be suited for a period of rising interest rates. This is because they remain invested in lower rate bonds only for a short period so that you can eventually get the benefit of higher coupon rate offerings.

Debt funds, as is, can be opted for short to medium investing terms, so this strategy can fit well with most debt investors’ investing plan

For long term investors

In actuality, the market anticipation for increasing repo rates seems to be built into long term yield curves, with long term investment yield curves on the rise, in fact today higher than its long-term average.

This can make it prudent for the long-term investor to begin allocating to debt as well.

Looking to practically eliminate this duration risk

If long-term investing in debt funds but without the duration risk is your ask, then you can opt for an effective mid/long term debt investing strategy. This includes debt mutual funds that have a fixed tenure – they invest in debt instruments such as bonds and securities that have a maturity in line with the tenure of the FMP. Apart from the fact these funds have transparency with regards to returns as well as maturity date, they can also have the potential to eliminate duration risk linked to changing interest rates.

While yes it may seem that hiked rates adversely impact debt funds, these changes ultimately iron out. Sticking to your intended investing horizon could be the key. Do not let the fear of rising interest rates keep you from investing in debt funds, instead adopt a strategy that helps manage the accompanying duration risk!

Read More:

What is Mutual Fund?

What is debt Mutual Fund?

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.