InvestorQ : Which Debt mutual funds will be affected most by the Reserve Bank of India's (RBI) expected rate increase?
Diya Chitale made post

Which Debt mutual funds will be affected most by the Reserve Bank of India's (RBI) expected rate increase?

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Siya Saran answered.
5 months ago
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To explain this, let us first understand how debt funds work. The prices of bonds and interest rates are inversely proportional to each other. If the interest rates increase from the current level, the prices of fixed income securities decrease. Similarly, if the interest rates decrease, the prices of fixed income securities increase.  

Now, coming back to debt funds. Essentially, a subscriber to a debt mutual fund is indirectly investing in bonds through the mutual fund house. The Net Asset Value (NAV) of such mutual funds is calculated as a sum of the price of the bond and coupon payments (interest accrued). Since these funds are traded in secondary markets, the interest accrued is calculated on a daily basis to realize the accurate NAV of the fund.

The NAV of debt funds varies with the prices of bonds they hold and the interest being accrued on them. Since the prices of the bonds are governed by the interest rates, a change in the interest rate is reflected in the NAV of the debt fund. The NAVs of the debt mutual fund hold the same inverse relationship with interest rates. The NAVs of debt funds are recorded lower when the interest rates increase and the NAVs increase if the interest rates decrease. 

However, bond maturities play a vital role in this nexus. Bonds nearing maturity (for example, within a year) tend to bear little impact by the change of interest rate. On the other hand, long-term bonds until maturity can be significantly impacted by changing rates. Thus, short-duration mutual funds tend to be less sensitive to interest rate changes as compared to long-duration bonds. So, funds that have higher exposure to long-term and medium-term bonds will be impacted by RBI’s rate increase, when it happens.
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