How Repo Rate Affects Debt Funds?

Picture depicts RBI's logo and Repo Rate Visual

Actual Question:

How does RBI repo rate affect the performance of debt mutual funds?

Answer:

Dear Friend!

Reserve Bank of India’s (RBI’s) ‘Repo Rate’ strongly influences the lending rates of commercial banks. If the repo rate is cut, the lending rates fall. On the other hand if repo rate is increased, the cost of borrowings go up.

How RBI’s repo rates will affect the performance of debt mutual funds is difficult to predict. One simple logical expectation is that if repo rates go up, the floating lending rates will go op and will positively impact the banks and other lending institutions and therefore, indirectly, the prospects debt mutual funds. But fixed interest rate loans are not affected. Mostly bonds, government securities, treasury notes are fixed interest rate instruments and debt mutual funds predominantly invest in such loans. In such a scenario there are no gains or losses in the short and medium terms.

Yet another argument could be that a fall in repo rate and consequently commercial lending rates to spur overall quantum of borrowings and therefore the prospects of debt mutual funds could brighten.

Predicting the consequences of events like changes in repo rates is not only difficult but fraught with huge risks. Therefore one should never make investment decisions based on such events/ actions. One should make good assessment about the fund, invest and simply leave it.

Anyway, friend, what are the special reasons for your interest in debt mutual funds? Debt funds do not make the investor rich or wealthy. There is no scope for increase in either recurring income or for capital appreciation. Debt funds are suitable only for those who have a large corpus of investible funds out of which one expects a regular income like charitable foundations, universities, pension funds, rich individuals and generally not for a majority salaried and middle income individuals. For them only well-diversified growth funds or exchange traded funds are suitable to create wealth in the long term.

Suggested Further Reading:

• What is Repo Rate?
• What are Repo and Reverse Repo Rates?
• How to Choose the Right Mutual Fund to Invest?
• Is there a Special Benefit in Being Invested For a Long Time in a Debt Fund?
• How can Investors Capture the Benefits of the Economic Prosperity of a Nation?
• What is an Exchange Traded Fund?

Thank you,

With Best Regards

Anand

What are Repo and Reverse Repo Rates?

Dear Mr.Satinderpal Singh

Sorry for the delay in answering, a good question.

First address the meaning of these two terms and then their significance.

The ‘Repo Rate’ is the rate at which the Reserve Bank of India (RBI) is willing to lend money to commercial banks. The ‘Reverse Repo Rate’ is the rate at which the RBI is willing to pay to accept surplus money lying with commercial banks.

Now let us address the significance of these rates. These rates have the significance of influencing the market interest rates for the whole economy. There is no direct and binding linkage between the RBI denominated rates and banks’ rates but it only has indirect, persuasive influence. When RBI lowers the two rates, it is sending a strong and clear signal that RBI believes the lending and deposit rates need to go down. The actual reduction achieved out of competition. One bank takes the cue and reduces its rates and others will follow. This is called the transmission of interest rate changes.

However, it has happened in the recent past that the commercial banks refused to transmit the rate cuts, forcing the RBI to intervene (again only persuasive) and speak out that there was a clear need for transmission of the rate cut.

Converse persuasion attempts were also made in the recent past where the central government and commercial banks desired a rate cut but the RBI did not oblige and the commercial banks went ahead on their own and cut rates thus putting pressure on the RBI to cut Repo and Reverse Repo rates.

In conclusion Repo and Reverse Repo rates are RBI’s interest rate policy tools that strongly influence the general lending and deposit interest rates by commercial banks and other financial institutions.

Thank you,

With Best Regards,

Anand

Please Note: This is almost a reproduction of the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.