The term “interest rate” refers to the specific rate that is set by the Central Bank. This rate is known as repo rate and is determined by the Reserve Bank of India (RBI) in its bi-monthly monetary policy. The RBI watches the economic situation and accordingly determines the interest rate that becomes the base lending rate.
A debt Mutual fund invests in instruments such as Treasury Bills, Government Securities, and corporate bonds of varied tenures. These securities come with a fixed maturity and offer fixed interest rates. A cut in repo rate is good news for debt funds. This is because when the interest rate falls, the securities already existing in the fund’s portfolio at an advantage. Existing securities will obviously have a higher coupon rate than the newer ones. Since debt paper is traded, the existing (debt) paper (or securities) go up in value. This brings the yield of the old securities in alignment with the current interest rates. YTM or yield to maturity of the old paper and newer one will converge. Convergence of YTM leads to appreciation in the capital value of the existing security. And appreciated value gets reflected in the NAV. Hence, better returns for “fixed income” or “debt fund” investors.
However, bonds nearing maturity (for example, within a year) tend to bear little impact by the change of interest rate. This is because, at maturity, the bond issuer will redeem the par value of the bond to the bond owner. As the maturity date approaches, the market value of a bond converges with its par value. On the other hand, bonds with longer tenure can be significantly impacted by changing rates.
Thus, short-term debt funds, money market funds are less vulnerable to the interest rate volatility.
In general, when the interest rate is rising, it typically makes Equity mutual funds, less attractive. This is because the cost of borrowing increases and businesses get adversely impacted. Capital investments get expensive and profitability takes a hit.