A reader says, “When interest rates go high, the value of debt mutual fund investment decreases (although reason and logic are well understood). There is nothing one can do about it. However, if money is in a bank fixed deposit (instead of a mutual debt fund), one can always rebook the FD at a higher rate. So, FD appears to be better than a debt mutual fund in a scenario of rising interest rates for a layman. Your insight will help people understand the truth if it is otherwise”.
Note: The article was written at a time when interest rates have peaked and plateaued. This situation may change when the article is published. However, we only discuss general principles, which are evergreen.
The short answer is that the layman is often better off with an FD or an RD than debt mutual funds. Especially now when all debt fund gains are taxed as per slab. Debt funds still make sense for long-term goals. However, the journey will be rough when interest rates increase.
The reader rightly pointed out that most investors shift from debt funds to FDs when rates increase because FDs seem better. However, it would not be possible to practically time the exit to FDs and entry back into debt funds. Therefore, investors should appreciate risks and be patient if they wish to choose long term debt funds. These products still have favourable taxation compared to FDs because (1) we pay tax only on redemption (FDs are taxed each year), and (2) we pay tax only on units redeemed. There is no need to break the entire FD.
The general thumb rule in the bond market is that the longer the duration of the bond is, the more the price will fluctuate due to speculative demand vs supply forces. Thus, a mutual fund buying long term bonds and, therefore, with a higher average portfolio maturity will have a more volatile NAV (NAV each day depends on the current market price of the bonds in the portfolio).
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When we refer to increasing interest rates, we refer to the overnight borrowing rate known as the repo rate. See: Understanding Repo Rate and Reverse Repo Rate. This overnight rate change will slowly percolate to the bond market’s higher and higher maturity segments.
Theoretically, we expect the NAV of long-term debt mutual funds to fall once the repo rate increases. This is because the market expects new long term bonds with higher interest rates, and therefore the current bonds lose value due to lower demand.
In practice, the bond market constantly speculates about rate movements and prices in rate changes. Sometimes, the rate can be hiked due to unexpected events, which can result in a crash in bond prices. This last happened in July 2013 when the RBI hiked the repo rate suddenly to stem the Rupee depreciation.
Gilt funds, dynamic bond funds and other long term debt fund managers change the portfolio’s average maturity according to anticipated interest rate movements. If they expect rates to increase, they tend to buy more short-term bonds and vice versa. Thus, many long-term debt funds can stem the fall in NAV when rates change or are expected to change. This may not happen all the time, though.
When rates increase, short-term debt funds slowly get higher returns. It will not happen immediately because the current bonds will have to mature, and the fund manager will gradually replace them with new bonds carrying higher interest rates. Unlike their long-term counterparts, most funds buy and hold until maturity in the short-term debt fund space.
Are FDs better than debt mutual funds when interest rates increase?
- For short-term goals (<5Y), FDs and RDs are better anyway, even for expert debt fund investors.
- For intermediate-term goals ( 5Y to 10Y), debt funds are suitable for experienced investors only. However, it is not practical to move to FDs and back to debt funds depending on rate movements. Those who appreciate risks can consider a fund like the Edelweiss Short Duration Index Fund for such durations.
- For long-term goals (>10Y), we recommend a debt mutual fund for all investors (to be decided by the asset allocation and goal needs). Experienced investors can consider funds like conservative hybrid funds like the one from Parag Parikh, a corporate bond fund, or a gilt fund. For suggestions, see Handpicked List of Mutual Funds (PlumbLine). New investors can deploy a small amount or a small SIP in one of these funds, gain the experience* over a few years and then invest more gradually. * This includes studying more about debt fund risks and monthly factsheets.
- Note: A debt fund is not guaranteed to beat an FD (before tax) over any duration. If you cannot accept this, do not invest in them.
Resources:
- An introduction to debt mutual funds for new investors
- Debt and hybrid mutual fund screener for selection, tracking, learning
- Free E-book: A Beginner’s Guide To Investing in Debt Mutual Funds
- Three Key Mutual Fund Terms All Retail Investors Should Know
- Debt Mutual Fund Categories Explained For Retail Investors
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