Has this ever happened to you?
You booked a 1 year FD of say Rs 1 Lakh @10%. The next day interest rates increased to 11%
You would feel a certain degree of regret but you will probably shrug your shoulders and say OK, never mind. Similarly, if the interest rates were to go down, you will feel happy and consider yourself lucky to have booked your FD at the older, higher rate.
What if we told you that when the interest rates went up, your 1 lakh FD became less valuable by almost Rs 1000?
I'm sure that I have your attention now :)
Here's how the math works:
You booked a 1 year FD of say Rs 1 Lakh @10%. Let's state it differently. You invested Rs 1 lakhs and after 1 year you will get Rs 1.1 lakh.
With the new interest rate of 11%, you can book a 1 year FD of approx Rs 99,099 @ 11% and still get Rs 1.1 Lakhs after one year.
Or, you only need to invest Rs 99,099 to get Rs 1.1 lakh after one year.
In a way,
Yesterday your FD which earns 10% was worth Rs 1 lakh
But, today's value of the same FD is only Rs 99,099.
How big is this impact?
Here's a calculation of the new value of your 1 lakh FD when interest rates change. It depends on the change in interest rate and the tenure of your FD.
You will notice that:
- Your FD becomes less valuable when interest rates go up and becomes more valuable when they go down
- If interest rate change is more, the change in value is more.
- The impact is more dramatic when the tenure of FD is longer, and negligible when the tenure is short. 1 or 3 months FDs see hardly any change, while 10-year FDs gain or lose almost 9% of value.
We all know that interest rate changes happen often. Not always the day after you booked your FD, but definitely a few weeks or months later.
But, we don't worry about it because no one tells us the new value of our FD. If someone did, we will start worrying.
So why did I waste your time with this interesting but totally useless theoretical stuff?
While you and I don't calculate the value of our FD every time interest rates change, debt funds have to calculate and report the change in the value of their FDs. (Most debt funds invest in bank CDs, which are like FDs. Corporate bonds can also be understood as FDs but booked with companies rather than banks.)
This calculation then affects the NAV of the fund. The impact varies depending on the type of debt fund.
The funds that invest in very very short term bonds of less than 3 months - namely liquid funds - see a very tiny, almost unnoticeable impact. The funds that invest in bonds of up to 1 year - namely ultra short term debt funds - see a noticeable but small impact. Longer duration funds - say a dynamic bond fund - will see a bigger impact. Long-term gilt funds usually see the biggest impact.
So, when debt funds lose value they are behaving exactly like FDs - just that we don't know it.
Does this mean you should only invest in short term FDs and liquid funds?
No. This means that you should select debt funds that match your intended holding period.
This is why Scripbox has 2 separate categories which invest in debt funds
Emergency Fund: is for holding period less than a year and invests in an ultra short term fund which does not react much to interest rate changes.
Short Term Money: is for holding period of 1-5 years and invests in 3 different kinds of debt funds to ensure that the impact of interest rate movements is smoothened but you also gain from these movements.
I recommend that you also read this article: Hey, my debt funds have crashed... What's happening? It extends this explanation further.