Interest rate risk is a type of risk that is associated with mutual fund investment. It affects those funds that invest in fixed-income securities such as bonds.
Interest rate can play a crucial part in deciding the destiny of your investment. When the US Federal Reserve announced in 2013 that it would start reducing its bond-buying program, it led to a rise in interest rates. Consequently, the value of bond mutual funds fell, causing investors who were holding these mutual funds to experience losses.
Interest rate risk is the risk of a change in interest rates affecting the value of your securities held by the mutual fund.
For example, when interest rates rise, the value of the debt securities declines, leading to a fall in the fund’s Net Asset Value. This, in turn, leads to a decline in your return. Conversely, when interest rates fall, bond prices rise, leading to an increase in the fund’s Net Asset Value.
How to avoid interest rate risk in mutual fund investments?
Invest in short-term bond funds
If you are looking for a safer investment option, you should consider short-term bond funds. These types of funds have a shorter maturity period compared to other bond funds. Therefore the invested money will be returned more quickly.
Additionally, short-term bond funds are less sensitive to interest rate changes. Hence, by investing in short-term bond funds, you can reduce your exposure to interest rate risk.
Invest in equity funds
Equity funds are less affected by interest rate changes. This means that if interest rates go up or down, the impact on equity funds is minimal. Consequently, investment in equity funds can avoid interest rate risk.
In other words, you do not have to worry about losing money due to fluctuations in interest rates. Therefore, equity funds can be a good investment option for you to minimize the impact of interest rate changes.
Invest in floating rate funds
Floating rate funds are a type of investment that focuses on debt securities with a floating interest rate. Floating rate funds adjust their interest payments to reflect the current market rates. This means that they are less sensitive to changes in interest rates.
By investing in floating rate funds, you can benefit from the flexibility of the floating rate structure. This makes you earn more interest when the rates go up and less when the rates go down.
Diversification
When it comes to investing, diversification is essential in reducing risk. You can spread your money across different types of investments, such as debt and equity funds through diversification. By doing so, you can reduce the chances of interest rate risk.
A mix of debt and equity funds can help balance out the impact of interest rate changes on the overall portfolio. For instance, when interest rates rise, bond prices fall, but stocks may perform better, and vice versa. Therefore, diversification can help you to maintain a stable portfolio.
You should carefully evaluate the interest rate risk of the mutual fund before investing. It is important to remember that interest rate risk can have a significant impact on the performance of your investment over the long term. So you should be prepared to ride out any fluctuations in the market.
