Repo Rate – Interest Rate – Debt Fund NAV coupling effect
Changes in interest rates can have both positive and negative effects. When Reserve Bank of India (RBI) changes the rate at which banks borrow money, i.e the Repo rate, this has a connecting and spreading effect across the entire market.
These interest rates also affect debt fund prices (their NAVs). There is an inverse relationship between debt fund prices and interest rates, meaning that as interest rates rise, NAVs fall, and as interest rates fall, NAVs prices rise.
One way that governments and businesses raise money is through the sale of debts. As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for debt funds will drop, causing their NAVs to drop. As interest rates fall, it becomes easier to borrow money, and many companies will issue new debts to finance expansion. This will cause the demand for debt funds to increase, forcing NAVs to rise.
Lets us assume that Mr. Sachin bought a 7 year bond having Face Value (principal) Rs. 1000 with interest rate 10%. After 2 years, Mr. Sachin wishes to sell his bond. But, the other bonds in the market currently have an interest (coupon) rate of 12%.
Here, Mr. Sachin will have to sell the bond at discount. The price at which a buyer will buy the bond is the price at which the bond will yield 12% returns. Therefore, the face value of the bond will come to approx. Rs. 910. A loss of Rs. 90/bond will be incurred and this exactly the effect of interest rate on NAVs of debt fund.
Similarly, exact opposite would have happened if the interest rates would have decreased to say 8% where the face value would have become approx. Rs. 1080 and a profit of Rs. 80/bond would be received.