US Fed Rate Hike: How Will It Impact Your Debt Funds?

The US Federal Reserve monetary policy committee unanimously raised interest rates by 0.25 per cent, citing elevated inflation as the reason.

The possibility of further rate hikes remains open considering the commentary by Jerome Powell, chair of the US Federal Reserve.

“We have covered a lot of ground, and the full effects of our tightening have yet to be felt. Looking ahead, we will continue to take a data-dependent approach in determining the extent of additional policy firming that may be appropriate,” said Powell while announcing the rate hike.

This hike is very much anticipated by the global markets and India, as well.

Says Abhishek Bisen, head of fixed income and fund manager, Kotak Mahindra Asset Management Company (AMC): “The federal open market committee (FOMC) hiked rates by 25 basis points (bps) taking the Fed fund rate to 5.25-5.50 per cent, which was on expected lines. In order to ensure that financial conditions do not ease prematurely, the Federal Reserve will continue to guide that further monetary actions will be data dependent. In our assessment, falling core inflation in the month ahead will headline at ~3 per cent, will give comfort to FOMC to stay on hold for rest of CY 2023.”

As a result of this Fed rate hike, along with soaring vegetable and crude prices, the Reserve Bank of India (RBI) may not cut rate any time soon. RBI may continue with its pause mode in the next policy meet which is scheduled on August 8-10, 2023.

As interest rates have a direct bearing on your debt funds returns, here are the key factors you should consider before investing in debt funds in this period.

Yield to Maturity (YTM): YTM reflects the expected future returns on a bond. Simply put, YTM is the total rate of return an investor earns if one holds the bond until maturity. For instance, a bond with a face value of Rs 1,000, a 5-year maturity, and a 7 per cent coupon will provide Rs. 70 as annual interest till the 5th year, followed by the principal amount.

Now let’s break down YTM with the same example: At the bond’s face value of Rs. 1,000 when issued, the coupon rate and yield are the same. However, yields change throughout the bond’s tenure. For instance, when interest rates rise, bond prices fall because demand for bonds fall, affecting the net asset value (NAV) of debt funds and their performance.

Simply put this, high YTM may indicate that a debt fund is more prone to interest-rate risk. It’s essential to use YTM as a gauge, but avoid relying solely on it.

Consistent Returns: When choosing a debt mutual fund, consistency in returns should be prioritised rather than one-off gains. So, as a rule, evaluate the fund’s performance across different market cycles compared to benchmarks and peers. Before investing, it should be ensured that consistency is observed over longer timeframes.

Fund Size: Fund size is another important factor you should consider for analysis in the case of debt funds, as the category typically sees huge inflows and outflows.

Avoid schemes with small corpuses. The reason is because fund houses don’t disclose if any investor owns a substantial chunk of outstanding units. If any such investor decides to redeem their holdings, the fund could be forced to sell holdings below the market rates, thus impacting returns.