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Impact of Interest Rates on Mutual Funds

The stock market is a platform that offers the infinite opportunity to make financial profits and achieve financial goals. Investing in the share market allow investors to make potential profits that not possible through fixed deposits (FDs) and public provident funds (PPFs). However, this would require a lot of understanding of the Indian & global stock market, fluctuation in crude oil prices, and interest rate decisions taken by Reserve Bank of India (RBI) even when you’ve invested in the mutual funds. It is very common to see that many mutual fund investors believe that less volatility made it easy in investing in the stock market without constant monitoring of the portfolio.

But, the truth is, ‘Volatility’ is not the only thing that could affect your investments. There are several others. One of those things that can highly impact your mutual funds is ‘Interest Rate Decisions’. As we said above, it is one of the things that you must be updated on – ‘All the time’.

If you’ve just started investing in mutual funds and have no idea ‘What interest rates really are?’ then you should continue reading. This go-to-guide will help you to understand the interest rate and how it can affect your mutual fund investments.

What is Interest Rate?

In India or other countries, the interest rate is called the federal funds rate set by the Federal Reserve (RBI in case of India). This is the interest rate that bank charges from other banks for very-short-term loans. This interest rate has certain effects on the banks’ finances. Thus, to offset the impact of these changes, the banks pass the costs along to their borrowers in the form of loan rates, credit card interest rates, and mortgage rates etc.

In short, when the interest rate rises, the banks usually increase the rate on loan and credit cards, but if it reduces, then it would be easy to borrow money in general.

Why do Interest Rate Changes in India?

If you know India is one of the biggest importers of crude oil. The country’s 80 percent of oil needs fulfill through imports. Since global oil prices are not willing to mellow down, the imported oil lead to the inflationary conditions within the country. Thus, the Reserve Bank of India increase or decrease repo rate (interest rate) in order to keep inflation under control.

If the interest rates are too low, then borrowing money becomes quite easy and cheap. This allows a consistent flow of cash into the country, which leads to a hike in prices called inflation. Conversely, if the interest rates are too high then borrowing money becomes very difficult and the economy suffers.

Impact of Interest Rates on Mutual Funds

As you can see that the fluctuation in interest rates can affect in different ways. Now the question is how it will affect mutual fund investors? Let’s take each scenario one-by-one.

Scenario One: Interest rates rise

From an MF investor’s perspective, when interest rate rises, the risk-free returns will go up since the government bond yield will rise. When that happens, the corporate bonds will also increase in interest rates and offer better returns. In this case, an investor will often go for the fixed return assets and plan to invest in bonds instead of uncertain, volatile equities. Because the borrowing money becomes easy, investors (or people) prefer to keep less capital in their mutual fund portfolios. If the mutual fund portfolios have less money to work with, the returns will vary with the capital amount. Furthermore, the stock market would take a dip when interest rate rises; ultimately affect mutual fund investors and shareholders.

Scenario Two: Interest rates fall

When the interest rate falls, the investors will find it difficult to borrow money, making difficult to purchase big goods like cars property among others. When that happens, the purchasing power of investors will start decreasing and they will end up investing in the share market believing to make potential profits from the volatility in the share market.

Final Thoughts: -

In a nutshell, the rising interest rates make mutual funds and other equity-based investments less attracting. When that happens, investors will find it difficult to make potential profits. Thus, it is important to get the proper understanding of the interest rates and to be aware of RBI’s monetary policies. To stay updated on the interest rate decisions by RBI and other economic indicators, use the live economic calendar and make better investment decisions.      

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