Mutual funds have grown in popularity over the years as retail investors look to them as a means to accumulate wealth for various life goals. While many types of funds have delivered remarkable returns, there remains some scepticism about their value in periods of low interest rates.
After the Reserve Bank of India (RBI) decided to halt increases in key interest rates during recent monetary policy reviews, there is increasing speculation about potential rate cuts shortly. This leads to questions about the performance of mutual funds in a low-rate environment and whether it is wise to invest in them under these conditions.
Understanding a Low-Interest Rate Environment
A low-interest rate environment occurs when current interest rates are significantly lower than historical norms. This scenario typically makes borrowing less expensive. The main intention behind setting low interest rates is to boost economic activity by promoting borrowing and spending.
Dynamic Funds Might Do Well
Dynamic Bond funds are anticipated to perform favourably in environments characterised by low interest rates. These funds predominantly invest in bonds issued by various government entities and corporations. There exists an inverse relationship between bond prices and interest rates, suggesting that lower interest rates typically lead to higher bond prices and vice versa.
During periods of low interest rates, the increase in bond prices can elevate the net asset value (NAV) of a fund, potentially yielding greater returns for investors. Furthermore, the yield—or interest income—derived from the fixed-income securities within mutual funds may increase, offering the possibility of enhanced gains.
Impact on Equity Funds
Equity funds stand to gain from a low-interest rate environment as well. Lower interest rates make borrowing more affordable for companies, which can improve their operational performance and profitability. This improvement can, in turn, lead to higher returns from equity mutual funds and augment the overall value of your investment portfolio.
Conversely, when interest rates are high, borrowing costs for companies escalate, adversely affecting their profitability. This scenario can result in diminished returns from equity funds.
Also Read More About What are Equity Mutual Funds?
Key Considerations for SIP Investing in Falling Interest Rate Regime
- Understanding Volatility and Risk: Dynamic bond funds inherently carry a higher interest rate risk, which can lead to fluctuations in short-term performance. Investors should be aware of the potential for volatility and also consider the credit and liquidity risks associated with these funds. It’s crucial to know the lowest credit quality the fund manager can invest in, as this will give insights into the credit risk of the fund.
- Evaluating Fund Managers: The effectiveness of dynamic bond funds largely depends on the fund manager’s discretion to adjust durations based on their outlook on interest rates. Investors should examine the fund manager’s track record closely. Vivek Banka, co-founder of GoalTeller, advises, “Understanding the maximum duration permitted can reveal the extent of risk the manager can assume. Longer maturities may pose higher risks during rate hikes.”
- Portfolio Allocation and Tax Considerations: It’s advisable for investors to limit their exposure to these funds to no more than 20% of their total debt portfolio allocation. Furthermore, with the new provisions under the Finance Bill 2023-24, debt funds holding less than 35% in equity will face taxation at marginal rates on capital gains as they are classified as other income.
- Optimal Holding Period: A typical holding period for dynamic bond funds should be between three to five years. This duration allows investors to navigate various interest rate cycles and benefit from strategic adjustments made by the fund manager. Sonam Srivastava, founder and fund manager at Wright Research, notes, “An extended holding period can help in maximising returns by reducing the impact of market volatility and aiding in achieving long-term financial goals.”
- Investment Strategy Across Durations: Fund managers of dynamic bond funds invest across different durations—short-term, medium-term, and long-term—based on their views of the interest rates. Over a period of four to five years, these funds can potentially offer better returns compared to other thematic debt funds while ensuring that they do not exceed 20% of your total debt allocation in the portfolio.
Also Read More About What is SIP Investment?
Investing Wisdom for Mutual Funds in Low Interest Rate Environments
Navigating investments in mutual funds during periods of low interest rates can adhere to traditional principles. Key strategies include:
- Embrace Comprehensive Diversification: It’s essential to spread your investments across various fund types, including both debt and equity. This strategy not only captures potential gains from different market conditions but also stabilises your portfolio over time. A balanced mix of equity and debt can safeguard your investments and promote growth.
- Continuously Assess Your Portfolio: Investing in mutual funds is an ongoing process. Regular assessment of your portfolio is crucial to ensure it remains in sync with your financial objectives. Adjustments may be needed to capitalise on positive market trends or to shield your earnings during downturns. Always consider professional advice before making impulsive decisions.
Final Thoughts
Both debt and equity mutual funds can prosper in a low-interest rate environment. With inflation at a peak and indications from major central banks, such as the RBI, about potential rate cuts, the financial landscape may favour such investment strategies. Keep your investments active to enjoy the benefits.
Ready to start your investment journey? Open a demat account with Angel One today and begin building a diversified investment portfolio tailored to the evolving market conditions.
FAQs
How do low-interest rates affect SIP investments?
Low-interest rates generally benefit SIP investments by boosting bond prices, enhancing returns from debt funds, and reducing borrowing costs for companies, which can improve equity fund performance and overall portfolio growth.
What risks should I be aware of when investing in dynamic bond funds?
Dynamic bond funds carry higher interest rate risks and potential credit and liquidity risks. It’s important to evaluate the fund manager’s strategy, track record, and the credit quality of the fund’s investments.
How should I diversify my portfolio in a low-interest rate environment?
Diversify by including both debt and equity funds, limiting exposure to high-risk funds to no more than 20% of your debt allocation, and regularly reviewing your portfolio to ensure alignment with your financial goals.
