Repo Rate Cut: How Does It Impact Debt Mutual Fund Investors?

The Reserve Bank of India (RBI) cut the repo rate by 25 basis points bringing it down to 6.25% on Friday 7, February. This rate cut will impact borrowings and fixed-income instruments like debt mutual funds. The impact on interest rates is crucial in debt funds, and understanding its impact is important. In this article, let’s understand what the repo rate is and how the rate cut impacts debt mutual fund investors. 

What is Repo Rate?

The Repo Rate is the rate at which a commercial bank borrows money from the Reserve Bank of India (RBI). Let’s understand how this works. Commercial banks require funds for operation, so in times of shortage, they contact the RBI. The RBI agrees to lend money to these commercial banks in exchange for securities like Bonds and Treasury bills. 

These bonds and T-bills act as collateral for the central bank. Now, the central bank sets a rate called the repo rate, which is also short for ‘Repurchase Agreement’. The repo rate is the interest rate at which commercial banks borrow from the RBI, agreeing to repurchase the pledged securities later at a higher price, which includes the interest charged by the RBI. 

Let’s understand this with an example. Say a commercial bank needs ₹100 crores for short-term liquidity. It approaches the RBI for funds. The RBI agrees to lend the money for Government bonds worth ₹100 crores at a repo rate of 6.25%. The commercial bank repurchases the bond after one month. The banks will now pay the RBI ₹100 crores + 6.25% interest rate to repurchase the bonds and close the liability.

Why did RBI cut the Repo Rate?

RBI cut the repo rate for the first time in 5 years after 2020. Here’s a representation of how India’s interest rate has moved over the years. 

Source: Trading Economics

The repo rate holds significant importance in how it affects the economy, consumers, and investors. Here are a few reasons why RBI cuts the repo rate:

1. To increase liquidity

When RBI reduces the repo rate, it offers loans to banks at cheaper rates. Thereby, improving liquidity. Commercial banks adjust their interest rate according to the repo rate, hence making borrowings for businesses and consumers cheaper and in turn stimulating a strong credit flow in the economy.

2. To support financial markets

Since the repo rate cut makes borrowing for banks cheaper, they do not need to rely on fixed deposits for liquidity. Hence, banks reduce interest rates on long-term deposits. Making the equity market a more attractive option for investors vs. FDs and savings accounts.

How does the Repo Rate impact Debt Mutual Fund Investors?

Interest rates and debt funds have an inverse relationship, here's how:

When RBI cuts the Repo Rate

A repo rate cut has a positive impact on debt mutual fund investors.

• When RBI reduces interest rates, existing bonds that were issued at higher interest rates become more attractive to investors.
• Older bonds will yield better returns than new bonds with lower interest rates. 
• This drives the bond prices up, thereby increasing the NAV (Net Asset Value) of a debt mutual fund. 

When RBI increases the Repo Rate

However, say had the RBI increased the repo rate, it would have hurt debt mutual fund investors, here’s how: 

• New bonds with high interest rates would float in the market. 
• Investors would prefer new bonds over older ones with low interest rates. 
• This would lead to a decline in bond prices in turn reducing the NAV of a debt fund.

In conclusion, debt mutual fund investors benefit from a falling repo rate and they need to be cautious when rates are rising. The impact of repo rate however differs, in short-term and long-term debt. Let’s understand the implications in both scenarios.

What is the impact on long-term debt funds?

A long-duration debt mutual fund invests in bonds with a higher Modified duration, meaning the bonds have a longer maturity period. This makes them more sensitive to interest rate changes.

When the RBI cuts the repo rate, the impact on long-duration debt funds is higher. Here’s why:

• These funds hold bonds with higher interest rates for an extended period.
• Even if new bonds in the market offer lower rates due to the cut, your fund’s existing bonds will continue generating higher returns.
• Since bond prices rise when interest rates fall, the NAV of long-duration debt funds increases more compared to short-duration funds.

For example: Let’s say you invested in a long-duration debt mutual fund that holds bonds with a 6.5% interest rate and a maturity of 10 years. Even if the repo rate drops, your bond will continue to yield returns at 6.5% until maturity. This means investors in long-duration debt funds benefit from a rate cut for a longer period, as their bonds remain locked in at higher yields.

What is the impact on short-term debt funds?

A short-duration debt mutual fund, on the other hand, invests in bonds with a shorter Modified duration, meaning the bonds have a shorter maturity period. This makes them less sensitive to interest rate changes.

Meaning, that when the RBI cuts the repo rate, the impact on short-duration debt funds is relatively small and does not last very long. Here’s why:

• These funds hold bonds with the old interest rates for a shorter period.
• Bonds in these mutual funds will mature and the fund manager will have to deploy investments in new bonds with lower interest rates.
• Since bond prices rise when interest rates fall, the NAV will increase, however, the increment will be short-lived considering the fund will eventually invest in bonds with lower interest rates.  

This means investors in long-duration debt funds benefit from a rate cut for a longer period, as their bonds remain locked in at higher yields.

What should Debt Mutual Fund investors do now?

When the RBI cuts interest rates, investors in long-duration debt mutual funds may see potential benefits, provided they are comfortable with a longer investment horizon. Since bond prices tend to rise when interest rates fall, long-duration funds have historically reacted more positively to such rate cuts.

Let’s take a look at how repo rate cuts have played out in the past.

In January 2019, the repo rate was at 6.5%, and over a series of cuts, it dropped to 4% by May 2022, a decline of 2.5 percentage points.

During the same period, the yield on a long-duration mutual fund grew by approximately 21%. This was primarily because these funds held bonds with longer maturities, allowing them to retain higher interest rates even as market rates declined.

A repo rate cut can influence debt mutual funds, particularly those with longer durations, but outcomes depend on multiple factors, including market conditions, fund selection, and investment horizon. For investors, this could be a good time to review and realign debt fund holdings based on risk tolerance and long-term goals.

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