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Which debt instruments should you invest in during rise in interest rates

ICICI Securities 25 Jul 2022 0 COMMENT

Introduction

You may have noticed that goods and services have been getting more expensive recently. Inflation has been rising worldwide, and India is no exception. With prices rising steadily, the Reserve Bank of India (RBI) has wielded one of its most common weapons to tackle inflation—increasing interest rates.

For a second time in just about a month, the RBI has hiked the repo rate or the interest rate at which the central bank lends to other commercial banks to 4.90%. For debt investors, this is bad news. Why? The value of an existing debt investment falls when interest rates rise.

Understanding the relationship between interest rates and the value of debt investment

The prices of bonds or any other debt investment is inversely related to interest rates. For instance, if interest rates increase, then bond prices fall. If interest rates decline, then the prices of bonds increases.

Let’s assume the RBI hikes interest rates. Then new bonds will be issued at higher coupon rates. They will become more attractive than your older bond. Consequently, the older bonds also tend to match the current market yield, leading to a decline in prices.

If the RBI cuts interest rates, the reverse will be true. Your existing bond will become more attractive because new bonds will be issued at lower coupons. Yield of old bonds tend to fall, pushing up the price.

Now extend this idea to debt mutual funds. Rising interest rates will make the net asset value (NAV) of debt funds fall, while falling interest rates will increase their NAVs.

Additional read: How Interest Rates affect Bond Prices

How to invest during an interest rate hike? 

Long-duration debt fund investments are not profitable when interest rates are on the rise. Instead, short-duration debt mutual funds are a better option to consider. The impact of interest rate risk on short-term fixed income securities is lower than on long-term securities.

Ultra-short duration debt funds are one of the options to consider. Ultra-short duration debt funds invest in fixed income securities with duration of three to six months. This could range from treasury bills and government securities to commercial paper and short-term bonds. Short-duration debt instruments are relatively immune to interest rate risks, making them less volatile investments during a rising interest rate scenario.

Another option is to invest in floating-rate funds. A floating rate fund is a debt mutual fund that invests in debt securities with a variable or floating interest rate. The returns on these instruments are pegged to a benchmark rate. When interest rates rise, the returns on these investments also increase. Therefore, they are an effective way to beat interest rate risk.

Money market debt funds can also be an option to consider for a slightly longer investment horizon, say about six months to a year. While the interest rate risk of these debt funds is higher than ultra-short debt funds or floating rate funds, they are likely to provide better returns for the long duration.

Fixed maturity Plans, popularly known as FMP, could also be a good option as these plans don’t have any interest risk and the objective is to hold the security until maturity. But, these funds come with a lock-in and one needs to keep them till the maturity of the scheme.

Takeaway

Investments in debt funds become unattractive during a rising interest rate scenario. However, as a risk-averse investor, you may still want to continue investing in debt mutual funds. In such a scenario, it is best to keep your investments limited to ultra-short duration funds, floating rate funds, FMPs or other debt funds with short durations to avoid interest rate risk.

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