How To Navigate Higher Interest Rates

Uday Dhoot: Essentially, debt mutual funds are buying into interest accruing bond securities. The basic principle of any kind of bond investment is that when interest rates go up, bond prices go down; and when interest rates go down, bond prices go up. Basically, interest rate and prices of bonds are inversely related.

Because mutual funds, unlike fixed deposits, have to be priced on a daily basis, the NAV gets priced based on how the bond securities are being priced. So, if interest rates go up, bond prices will go down. To that extent, NAVs of debt mutual funds will go down.

Within the debt category, there are various types of mutual funds. There is something called overnight funds and there are long duration G-Sec funds.

The interest rate risk of a debt mutual fund, which is basically how violently the NAV of the debt mutual fund will react to interest movement, depends essentially on the duration. The longer the duration of the underlying debt security or debt mutual fund that you hold, the higher will be the impact on the prices when the interest rates go up. The lower the duration, the lower the risk. So, if interest rates go up, debt funds are likely to see temporary negative returns – and temporary is an important bit here.

This impact may not be seen in overnight funds, in money market funds, because they hold very low duration securities which mature very quickly.

If a fixed deposit was listed, its price will keep going up and down as interest rates move. But if you hold the fixed deposit until maturity, and the company pays up the principal and the interest, you will still get what you were promised when you entered that investment. The same thing will happen with the debt security that you hold in your investments.

When talking about existing investments, this is an investment that could have been done maybe six months back, one year ago, or three years ago.

You need to think through your portfolio and figure out what kind of decision to take: How long have you been holding these investments? What is your investment horizon? What is your tax status – which tax bracket do you belong to? What is the underlying debt portfolio that you hold?

Let’s say you’re expecting interest rates to go up, and to that extent, chances are that debt fund returns might turn negative temporarily. What should you do? Ideally, you’d want to get out of that fund and invest in some other fund which will not react or get impacted in the same manner.

But every time you get out of a debt fund, you will have to pay capital gains tax. If you are holding the debt fund for less than 36 months, you end up paying tax as per your tax bracket.

Let’s say you’ve been earning 5% or 6% return on a debt fund today; it has not completed the 36 months window. You get out and pay almost one-third if you are in the highest tax bracket. Basically, 2% goes away straight as tax. Does it still make sense for you to move? Maybe not. Maybe, you are okay to live through that volatility for some period of time and stay invested.

Map your investment horizon with the type of debt funds that you have: What is your holding period? How long will it be before it becomes long-term, and then make a decision.

Typically, if you are holding roll-down schemes, target maturity debt funds, floating rate funds, ultra-short duration funds – and if your investment horizon matches with what you pulled – and obviously overnight in money market funds, then maybe there’s no need to do any changes.

But if you are holding long duration funds, and you want to step aside from the volatility for some time, maybe if the tax impact is very low, you want to get out and get back in.

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