How does inflation impact debt funds?

Every investment is about finding the right balance between risks and returns. Macro environment and demand-supply are a few of the factors that can affect your returns both positively and negatively. But there are some which are a part of our everyday lives, and which may just be out of the radar for some investors. One such risk is inflation, especially when it comes to your debt fund investments.

Let’s state at the outset that inflation is not always bad for your Debt funds in India; it may actually be beneficial as well. That is why it has been identified as a risk – sometimes it may pay off, other times it may not. Regardless, it is something to be aware of so let’s start with a brief on what inflation is

Inflation is a measure of the rise in prices over time in an economy. It is represented as a percentage and is usually measured over a certain period.

Inflation can be measured in several ways, but one of the most popular methods is via the changes in the consumer price index, also known as headline inflation.

It is a common phenomenon witnessed around the world, and inflation in moderation is considered good. This is because it represents growth in the economy. An economy grows when individuals and institutions spend more on products and service offerings. This leads to a greater demand for such offerings, which allows their providers to raise prices. The result is a rise in inflation. But while a certain pace of inflation is healthy, accelerating inflation can be detrimental to an economy as well as to the debt funds.

Speaking of debt funds, let’s take a brief look at them as well. Debt funds are mutual funds which invest in a diverse portfolio of fixed income securities. These securities could be issued by governments or corporates.

Speaking of debt funds, let’s take a brief look at them as well. Debt funds are mutual funds which invest in a diverse portfolio of fixed income securities. These securities could be issued by governments or corporates.

Inflation in itself does not impact the debt fund to invest. It is the change in policy rates, influenced by changes in inflation, which impacts these investments. The central bank of a country, like RBI in India, is responsible for making changes to policy rates. It’s part of its monetary policy. You can read more about how RBI’s policies affect your investments,
If inflation is not within a comfortable range, it may make the RBI act. One important thing to keep in mind is that the interest rates and bond prices are inversely correlated; if rates rise, prices fall.

If inflation falls below the comfort level, the RBI has to lower its interest rates. By doing that, it increases the supply of money in the financial system. This increased supply allows banks and financial institutions to lend more to people and companies at cheaper rates as more money is chasing less demand. Once demand increases, inflation increases to the desired level. On the other hand, if inflation is spiralling, the RBI raises rates which decreases the money supply and suppresses demand, thus bringing inflation back to its desirable range.

Thus, when interest rates rise because of higher inflation, bond prices fall, resulting in a decline in the value of the debt funds. Conversely, a decline in interest rates may be beneficial for the debt fund managers in India who may take this opportunity to make favourable changes to their fund portfolios. The longer the maturity of a debt fund, the more vulnerable it is to changes in interest rates. One of the major advantages of debt funds is that there are various maturities to choose from.

Inflation can either help or hurt your debt fund investment depending on the interest rate environment. Therefore, keeping a check on inflation is important. Armed with this basic information, you can choose the debt fund to invest based on your investment horizon and financial goals. You can either look at debt funds for one year or for longer maturities.

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