As an investor, it is natural to want security and stability while aiming for growth in your financial portfolio. While equity mutual funds can provide high returns, the risk is equally higher. This is why most investors invest in debt funds to get steady returns while mitigating the risks that come with equity funds. But even though debt funds offer a relatively low-risk investment option, they are still susceptible to risks, and one risk that can have a significant impact on your debt fund returns is interest rate risk.
Interest rate risk is a major concern for debt investors because the value of debt securities can be heavily impacted by rising or falling interest rates. When interest rates rise, the value of debt securities falls, and when interest rates decrease, the bond’s price goes up.
Interest rates are unpredictable and constantly fluctuate, which is why you must plan a solid strategy to manage these risks. So, let’s break down 5 key steps to manage interest rate risks in debt mutual funds and keep your investment secure.
- Understand the interest rate cycle
The interest rate cycle refers to the pattern of rising and falling interest rates. Understand how the interest rate cycle affects debt mutual funds.
If you expect interest rates to rise, it’s wise to invest in funds with shorter maturity periods. Short-term bonds and papers will not be affected much as they are not exposed to a long-term interest rate risk. And if you expect interest rates to fall, debt schemes with longer maturity periods can be a wise investment decision.
- Diversify your portfolio
Diversification is the key to managing investment risk. In the case of debt funds, diversifying within the fund category can help mitigate interest rate risk. Invest in overnight, liquid, low duration, and short term debt funds as they have low average maturity period which means they are less exposed to interest rate volatility. By diversifying through these funds and other mutual fund schemes, you can create a balanced portfolio that optimises risk and return.
- Invest in dynamic bond funds
Dynamic bond funds are mutual funds that invest in multiple debt securities, including government bonds, corporate bonds, and money market instruments.
These funds offer flexibility, allowing fund managers to react to changes in interest rates. In a rising interest rate scenario, these funds invest in short-term papers and bonds. And when interest rates start falling, they shift to longer-term bonds. This helps investors benefit from higher yields while driving down interest rate risk in their debt mutual fund portfolio.
- Stick to your risk profile and goals
Different types of debt funds suit different risk profiles of investors. Depending on your investment objectives, choose a debt fund that aligns with your financial goals and risk appetite. But once you select your fund, resist the urge to switch funds too often to try to earn higher returns. If you switch funds too often or invest based on speculative information, you can expose yourself to unnecessary interest rate risk.
- Laddering your investments
For example, you could invest 40% in a short-term debt fund, 20% in a medium duration debt fund and 40% in a long-duration fund. This allows you to take advantage of different interest rate cycles while minimising interest rate risk, as you are not bound to a single interest rate by spreading out maturity dates.
The bottom line
While uncertainty and volatility are inevitable in the market, you can mitigate some risks by researching and selecting funds with a track record of delivering consistent returns. Make sure you also consider other factors such as management reputation, the level of maturity risk associated with certain investments, any exit loads before finalising one fund.
Taking guidance from a financial advisor can further help you structure a strategy to get the most out of your mutual fund investments.