The impact of interest rates on mutual fund performance

Let’s assume you are planning for your retirement and decide to invest in mutual funds. After studying the market trends, you have selected the funds you want to invest in. But, just when you thought everything is set, you hear about a change in interest rates. What does this mean for your mutual fund performance and financial future?

Interest rates impact the economy and influence how people invest and spend their money. Any change in interest rates, whether an increase or a decrease, can lead to a significant flow of money between different investments. Thus, it is important to understand how interest rates work and how they affect your mutual fund schemes.

With that being said, here are detailed insights into the impact of interest rates on mutual fund performance and how you can protect your investments in changing economic conditions.

Interest rates and their impact on equity mutual funds

  • Cost of borrowing

When interest rates are low, borrowing money becomes less expensive and many businesses increase their investments to invest in growth and expansion projects. This stimulates economic activity, increases employment, and drives up stock prices.

When the interest rates are high, it can limit the borrowing capacity of businesses as they find it challenging to acquire capital at high rates. It can lead to a decrease in investment and negatively impact the stock market.

  • Impact on individual companies’ performance

When interest rates rise, companies that have borrowed money may struggle to meet their debt obligations. This can affect stock prices and returns from equity funds that hold those stocks. However, with lower interest rates, companies can borrow more freely and invest in growth opportunities. It can lead to higher stock prices and higher returns for equity funds.

  • Change in investor behaviour

Low interest rates give investors an opportunity to invest in riskier assets, such as stocks, to obtain higher returns. This can create more demand for equity mutual funds and higher prices. But when interest rates are high, investors usually shift their money into bonds or other fixed-income securities. It creates less demand for equity funds and lower their prices.

Interest rates and their impact on debt mutual funds

  • Impact of inverse correlation

When interest rates rise, existing bonds usually fall in value. This is because investors would prefer new securities and bonds that offer higher interest rates. When interest rates fall, the value of existing bonds increases as new bonds are issued with lower interest rates. As a result, investors tend to hold onto their existing bonds as they offer a higher return compared to the newly issued ones.

  • Effect on debt funds with different maturities

Long term securities are more sensitive to interest rate changes, and their value fluctuates more with every change. Short term debt funds are less exposed to interest rate changes and, thus, they experience lesser volatility in their returns.

  • Role of credit rating during high interest rates

Paying close attention to credit ratings is highly important to manage the debt portfolio from interest rate risk. The credit rating of a bond reflects the level of creditworthiness and financial stability of the issuer. So, high credit rated bonds are less sensitive to fluctuations in interest rates as compared to low credit rated bonds.

Bottom line

Interest rate changes can affect your mutual fund investments and their performance. Whether a portfolio is focused on equity or debt, changes in interest rates will have consequences for investors. To mitigate interest rate risks, a few strategies can be adopted, such as diversifying investments with different asset classes, maintaining a balanced portfolio that includes high quality bonds, blue chip stocks with strong fundamentals, and periodically rebalancing to adjust for changes in interest rates.

Also, while self-research is always helpful, consulting with a financial advisor can provide more useful insights and analysis. A financial advisor can assess your portfolio, offer personalised strategies to manage interest rate risks and suggest the best mutual funds for your investment objectives.