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Debt funds and interest rates: Navigating the see-saw
Understanding how changes in interest rates impact different categories of debt funds
05-Jun-2023 •Chirag Madia
In the words of Warren Buffett, "At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset."
These words rightly highlight the significant impact that changes in interest rates can have on the market.
This impact is particularly evident in the world of debt funds, where investors seek stability and consistent returns. Therefore, it is crucial to understand the intriguing dynamics that exist between interest rates and debt funds.
Interest rate impact on debt funds
| Category | When rates go up | When rates go down |
|---|---|---|
| Overnight | No impact as they invest in overnight securities | No impact |
| Liquid, Ultra-short duration/Low-duration/Money market | Tend to do well as funds are deployed at higher rates | No major impact due to investments in debt instruments with short maturity - 91 days to a year |
| Short-duration | Fairly limited impact as duration is one to three years | Benefit from rates moving down |
| Medium-duration | Volatile returns as duration is between three to four years | Can boost fund performance when rates decrease |
| Long-duration/Gilt | Vulnerable category as bond prices fall when rates rise | Can be rewarding |
| Dynamic bond | Returns may decrease due to flexibility in investing across maturities | Positive returns possible with falling rates |
| Credit risk | Unpredictable returns | Potential for significant upswings |
| Floater | Benefits from rising rates | Can generate returns when rates decrease |
What should you do in the event of an interest rate rise?
Consider investing in short-duration funds for your debt allocation.
These funds offer predictable and stable returns, making them suitable regardless of whether interest rates are rising or falling.
Suggested watch: Debt funds lose favourable tax treatment. What now?
