SIP Investing in a Falling Interest Rate Regime

SIPs work in low interest rates. Debt funds benefit from rising bond prices. Equity funds also benefit from lower borrowing costs for companies. Diversify your portfolio and review it regularly for favourable returns.

Mutual funds have grown in popularity over the past few years as they are seen as a means for retail investors to accumulate wealth for various life goals. While many types of funds have delivered remarkable returns, there remains some doubt about their value in a period of low interest rates.

After the Reserve Bank of India (RBI) decided to hold off on significant interest rate hikes during its recent monetary policy reviews, there is growing speculation about a possible rate cut soon. This raises 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. Borrowing is typically less expensive in this scenario. The main purpose of setting low interest rates is to boost economic activity by encouraging borrowing and spending.

Dynamic Funds Can Work Well

Dynamic bond funds are expected to perform favorably in low interest rate environments. These funds invest primarily in bonds issued by various government entities and corporations. There is an inverse relationship between bond prices and interest rates, suggesting that lower interest rates generally lead to higher bond prices.

During periods of low interest rates, an increase in bond prices can increase a fund's net asset value (NAV), potentially leading to higher returns for investors. In addition, the yield or interest income received from fixed income securities within the mutual fund may increase, leading to increased profit potential.

Impact on Equity Funds

Equity funds also benefit from a low interest rate environment. Lower interest rates make borrowing more affordable for companies, which can enhance their operating performance and profitability. As a result, this increase can lead to higher returns from equity mutual funds and increase the overall value of your investment portfolio.

Conversely, when interest rates are high, borrowing costs for companies increase, adversely affecting their profitability. This scenario can result in a reduction in income from equity funds.

Key considerations for SIP investing in a falling interest rate regime

Understanding volatility and risk: Dynamic bond funds generally have higher interest rate risk, which can cause fluctuations in their 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 is important to know the lowest credit quality a fund manager invests in, as it gives an idea about the fund’s credit risk.

Evaluating Fund Managers: The effectiveness of dynamic bond funds primarily depends on the fund manager’s discretion to adjust the duration based on his outlook on interest rates. Investors should closely examine the fund manager’s track record. Vivek Banka, Co-founder, GoalTeller, says, “Understanding the maximum duration approved can reveal the extent of risk the manager is willing to accept. Longer maturities may pose higher risk during rate hikes.”

Portfolio AllocationAllocation and Tax Considerations: Investors are advised to limit exposure to these funds to no more than 20% of their total debt portfolio allocation. Further, with the new provisions under Finance Bill 2023-24, debt funds holding less than 35% in equities will be taxed at marginal rates on capital gains as they are classified as other income.

Favourable holding period: A typical holding period for a dynamic bond fund should be between three and five years. This period allows investors to navigate various interest rate cycles and take advantage of strategic adjustments made by the fund manager. “An extended holding period can help maximize returns by mitigating the impact of market volatility and aid in achieving long-term financial goals,” said Sonam Shrivastava, founder and fund manager at Rite Research.

Investment strategy across duration: Fund managers of dynamic bond funds invest across short-term, medium-term and long-term based on interest rate considerations. Over a four to five year period these funds can deliver better returns than other thematic debt funds and ensure they do not exceed 20% of your total debt allocation in the portfolio.

Mutual funds are great investments in a low interest rate environment

Investing in mutual funds during a period of low interest rates can follow traditional principles. Key strategies include:

Practice wide diversification: It is essential to spread your investments across different types of funds, including both debt and equity. This strategy not only captures the potential gains from different market conditions but also stabilizes your portfolio over time. A balanced mix of equity and debt can protect your investment and promote growth.

Constantly Assess Your Portfolio: Investing in mutual funds is a continuous process. It is important for you to regularly evaluate your portfolio to ensure that it remains in sync with your financial objectives. Adjustments may be needed to capitalize on positive market trends or safeguard your income during a downturn. Always consider professional advice before making the appropriate decision.

Final Thoughts

Both debt and equity mutual funds can succeed in a low-interest rate environment. With signals about inflation and potential rate cuts from major central banks, such as the Reserve Bank of India, the financial landscape may favor 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 start building a diversified investment portfolio in line with the emerging market conditions.

FAQs
How do low interest rates affect SIP investments?

Lower interest rates typically benefit SIP investments by pushing up bond prices, increasing returns from debt funds and reducing borrowing costs for companies, which can improve equity fund performance and overall portfolio growth.