A reader says, “When interest rates go high, the value of debt mutual fund investment decreases (although reason and logic are well understood). There is nothing one can do about it. However, if money is in a bank fixed deposit (instead of a mutual debt fund), one can always rebook the FD at a higher rate. So, FD appears to be better than a debt mutual fund in a scenario of rising interest rates for a layman. Your insight will help people understand the truth if it is otherwise”.
Note: The article was written at a time when interest rates have peaked and plateaued. This situation may change when the article is published. However, we only discuss general principles, which are evergreen.
The short answer is that the layman is often better off with an FD or an RD than debt mutual funds. Especially now when all debt fund gains are taxed as per slab. Debt funds still make sense for long-term goals. However, the journey will be rough when interest rates increase.
The reader rightly pointed out that most investors shift from debt funds to FDs when rates increase because FDs seem better. However, it would not be possible to practically time the exit to FDs and entry back into debt funds. Therefore, investors should appreciate risks and be patient if they wish to choose long term debt funds. These products still have favourable taxation compared to FDs because (1) we pay tax only on redemption (FDs are taxed each year), and (2) we pay tax only on units redeemed. There is no need to break the entire FD.
The general thumb rule in the bond market is that the longer the duration of the bond is, the more the price will fluctuate due to speculative demand vs supply forces. Thus, a mutual fund buying long term bonds and, therefore, with a higher average portfolio maturity will have a more volatile NAV (NAV each day depends on the current market price of the bonds in the portfolio).
When we refer to increasing interest rates, we refer to the overnight borrowing rate known as the repo rate. See: Understanding Repo Rate and Reverse Repo Rate. This overnight rate change will slowly percolate to the bond market’s higher and higher maturity segments.
Theoretically, we expect the NAV of long-term debt mutual funds to fall once the repo rate increases. This is because the market expects new long term bonds with higher interest rates, and therefore the current bonds lose value due to lower demand.
In practice, the bond market constantly speculates about rate movements and prices in rate changes. Sometimes, the rate can be hiked due to unexpected events, which can result in a crash in bond prices. This last happened in July 2013 when the RBI hiked the repo rate suddenly to stem the Rupee depreciation.
Gilt funds, dynamic bond funds and other long term debt fund managers change the portfolio’s average maturity according to anticipated interest rate movements. If they expect rates to increase, they tend to buy more short-term bonds and vice versa. Thus, many long-term debt funds can stem the fall in NAV when rates change or are expected to change. This may not happen all the time, though.
When rates increase, short-term debt funds slowly get higher returns. It will not happen immediately because the current bonds will have to mature, and the fund manager will gradually replace them with new bonds carrying higher interest rates. Unlike their long-term counterparts, most funds buy and hold until maturity in the short-term debt fund space.
Are FDs better than debt mutual funds when interest rates increase?
- For short-term goals (<5Y), FDs and RDs are better anyway, even for expert debt fund investors.
- For intermediate-term goals ( 5Y to 10Y), debt funds are suitable for experienced investors only. However, it is not practical to move to FDs and back to debt funds depending on rate movements. Those who appreciate risks can consider a fund like the Edelweiss Short Duration Index Fund for such durations.
- For long-term goals (>10Y), we recommend a debt mutual fund for all investors (to be decided by the asset allocation and goal needs). Experienced investors can consider funds like conservative hybrid funds like the one from Parag Parikh, a corporate bond fund, or a gilt fund. For suggestions, see Handpicked List of Mutual Funds (PlumbLine). New investors can deploy a small amount or a small SIP in one of these funds, gain the experience* over a few years and then invest more gradually. * This includes studying more about debt fund risks and monthly factsheets.
- Note: A debt fund is not guaranteed to beat an FD (before tax) over any duration. If you cannot accept this, do not invest in them.
Resources:
Do share this article with your friends using the buttons below.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Podcast: Let’s Get RICH With PATTU! Every single Indian CAN grow their wealth!
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
🔥Now Watch Let’s Get Rich With Pattu தமிழில் (in Tamil)! 🔥
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit ‘reply’ to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. – Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.
Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)
