Debt funds and interest rates: Navigating the see-saw

Understanding how changes in interest rates impact different categories of debt funds

Debt funds and interest rates: Navigating the see-saw

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?

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