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 is Repo Rate?

India'a Current Repo Interest Rate stands at 6.25%

Repo rate is the most important monetary policy tool in the hands of the central banks.

An increase in Repo Rate reduces inflation.

How?

An increase in Repo Rate will make borrowing for commercial banks costly and therefore in turn they are forced to increase their lending rates. This will increase the borrowing costs of business and industry and they tend to curtail fresh investments. This in turn reduces the incomes of people who would have executed those expansion plans. This reduced income lowers the demand for consumption goods and consequently brings down the prices of these commodities. Lower commodity prices result in lower inflation.

This is how macro economics work or at least supposed to work.

The opposite happens if the Repo Rate is reduced - it spurs growth and inflation tends to go up.

In conclusion central banks increase Repo Rate if they want to tame inflation and reduce it if they want to spur growth.

The Reserve Bank of India (RBI) in its latest review meeting, contrary to wide expectations that the Repo rate will be reduced by 25 basis points, maintained the Repo rate at 6.25% indicating that it believes that any reduction would stoke inflation.

Suggested Further Study:

1. What Is Basis Points?
2. Yield Definition
3. Yield Slide
4. What is the Relationship Between a Bond's Market Price and Its Yield to Maturity?
5. What Is Internal Rate of Return or IRR In Simple Terms?
6. Value Investing