How will debt funds react to potential RBI rate cut?

How are returns from debt funds linked to interest rates? - Anonymous

Since many economists are expecting the Monetary Policy Committee (MPC) of the Reserve Bank of India to cut the repo rates by 0.25 per cent (25 basis points), from 6.5 per cent to 6.25 per cent, it is important to understand how debt funds will respond to the news.

Relationship between falling interest rates and debt funds

When interest rates fall, the bonds held by debt funds—especially those with higher coupon rates—become more valuable. That's because they continue to offer higher interest rates than newly issued ones. This pushes bond prices up, boosting the NAV of the debt fund.

The impact of a falling rate is more pronounced in long-duration funds. The existing long-term debt funds benefit greatly when rates decline, as the bonds held by them offer higher rates for a longer time. As a result, the net asset value (NAV) of long-duration debt funds goes up.

Relationship between rising rates and debt funds

Conversely, when interest rates rise, new bonds issued in the market offer higher yields, making existing bonds (which were issued at lower rates) less attractive. As a result, the prices of these older bonds fall, leading to a decline in the net asset value (NAV) of the debt fund.

Relationship between changing rates and interest income

Apart from this immediate price impact, debt funds also generate returns through interest income, which is received periodically (annually, semi-annually, or quarterly) based on the bonds they hold. As interest rates fluctuate, the yield on reinvested funds also changes, affecting the fund's overall returns.

In summary, debt funds experience a one-time impact due to interest rate shifts, followed by an ongoing effect on reinvestment yields. Understanding this dynamic is key to making informed debt fund investment decisions.

Also read: I am planning to invest in gold funds. How will it be taxed?

This article was originally published on February 06, 2025.