How mutual fund investors can benefit from rising interest rates

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The fall in interest rates which we have witnessed since April 2014 seems to have taken a pause. And, thanks to rising oil prices and rising inflation, interest rates are on its way up. The 10-year G-Sec yield has already moved from 6.46% to 7.82% over the last one year and is all set to cross the 8%-mark anytime soon. Sensing the inflationary conditions, RBI, in its latest June policy monetary meeting had increased the repo rate by 0.25% after a gap of almost four years and is expected to increase it further in this calendar year itself.

Taking advantage of rising rates

Inspite of rising cost of funds for the banks which would hurt the borrowers, debt investors may position themselves in a way to take advantage of the situation. This is creating an opportunity for investors looking to generate competitive returns from debt investments. Such investors need to capitalise from such a rising interest rate scenario. Investing in debt mutual funds provide a better alternative during the rising interest rate scenario. However, investors need to be careful with the choice of debt mutual funds as not all of them may generate decent returns. Recently, Sebi had reclassified funds including debt funds into 16 categories based on the duration of the underlying securities.

When interest rates are looking to go up, choose funds with shorter maturity profile like the short-term funds or ultra short term funds. When the interest rate rises, the price of existing bonds fall as there is expectation of higher rates on newer bonds. As prices fall, so do the NAV of the debt mutual funds. The impact, however, is more pronounced in debt funds with underlying securities which have longer maturity profile than on the shorter term funds. Such funds, therefore, provide stable and steady returns in rising interest rate scenario.

In addition to these funds, the conservative investors may consider liquid funds and fixed maturity plans. Importantly, avoid long-term funds as they may even result in the loss of capital when rates show rising trend. Till the rates are on the upward swing, stay invested in shorter duration funds.

Bank deposits

While interest rates of certain bank fixed deposits have increased, the post-tax return and the real return post-inflation may still be low compared to other alternative investments. Conservative investors looking for fixed return may alternatively consider fixed deposits of reputed companies with decent ratings. Their return overshadows bank deposits yet provide safety to the principal invested.

When interest rates rise, the tendency of investors is to park funds in fixed income investments. But, during these times, when interest rate shows a rising trend, the investors needs to be re-looking at the risk-return equation. As the G-Sec yield rises, so do the risk-free return and therefore the risk should be given importance over returns. As and when the interest rate cycle turns, investment in companies offering higher rate may face default risk.

Remember, debt funds are best suited for generating better tax-efficient returns when one’s goals are short to medium term in nature. They, anyhow, are not meant for wealth creation over the long term. While retired and senior citizen investors may consider them as a part of their debt portfolio to meet their regular income needs, others may consider debt funds as a de-risking strategy when nearing their goals.

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