How Interest Rates Affect Mutual Funds

Changing interest rates impact a wide range of financial products, from bonds to bank loans. Mutual fund investments are no different, so a basic understanding of how interest rates work and how they can affect your portfolio is an important step in ensuring you invest in products that continue to generate healthy returns for years to come.

The term "interest rate" is widely used to refer to the specific rate set by the Federal Reserve, or Fed. This rate is called the federal funds rate, but it is also commonly called the national rate. The federal funds rate is the interest rate banks charge other banks for very short-term loans, often just overnight. Because banks must close each day with a minimum amount of capital on reserve relative to the amount of money loaned out, a bank with surplus funds may lend the extra to a bank that comes up short so both banks can meet their capital quotas for the day. The interest the first bank charges the second bank for the privilege of borrowing cash is dictated by the federal funds rate.

This interest rate serves as the baseline for all other types of interest charges. For example, the discount rate is the rate at which banks may borrow money directly from the Fed, while the prime rate is the rate banks charge their most trustworthy borrowers. Both are directly impacted by changes in the fund rate.

The effect of changing interest rates does not end with banks' internal finances, however. To offset the impact of these changes, banks simply pass the costs along to their borrowers in the form of mortgage rates, loan rates and credit card interest rates. Though it is not required, it is very likely banks will raise their loan and credit rates if the funds rate increases. If the Fed reduces the funds rate, it becomes cheaper to borrow money in general.

The Federal Reserve raises and lowers the federal funds rate as a means of controlling inflation while still allowing the economy to thrive. If rates are too low, borrowing money becomes extremely cheap, allowing a rapid influx of cash into the economy, which in turn pushes up prices. This is called inflation, and it is the reason a movie ticket in 2015 costs nearly $15 even though it cost only $10 a few years ago. Conversely, if interest rates are too high, borrowing money becomes too expensive, and the economy suffers as businesses are no longer able to fund growth and individuals are not able to afford mortgages or car loans.

In the investment sector, bonds are the clearest example of the impact that changing interest rates can have on investment returns. Bonds are simply debt instruments issued by governments, municipalities and corporations to generate funds. When an investor purchases a bond, she is loaning money to the issuing entity in exchange for the promise of repayment at a later date and the guarantee of annual interest payments. Much like the owner of a home mortgage must pay a set amount of interest to the bank each month to compensate for the risk of default, bondholders receive periodic interest payments, called coupon payments, over the life of the bond.

Just like other types of debt, such as loans and credit cards, changes in the funds rate directly impact bond interest rates. When interest rates rise, the value of previously issued bonds with lower rates decreases. This is because an investor looking to purchase a bond would not purchase one with a 4% coupon rate if she could buy a bond with a 7% rate for the same price. To encourage investors to purchase older bonds with lower coupon payments, the prices of these bonds decline. Conversely, when interest rates go down, the value of previously issued bonds rises because they carry higher coupon rates than newly issued debt.

This impact is mirrored in other types of debt securities, such as notes, bills and corporate paper. In short, when the cost of interbank borrowing changes, it causes a ripple effect that impacts all other forms of borrowing in the economy.

When it comes to mutual funds, things can become a little complicated due to the diverse nature of their portfolios. However, when it comes to debt-oriented funds, the impact of changing interest rates is relatively clear. In general, bond funds tend to do well when interest rates decline because the securities already in the fund's portfolio likely carry higher coupon rates than newly issued bonds, and thus increase in value. If the Fed raises rates, however, bond funds may suffer because new bonds with higher coupon rates drive down the value of older bonds.

This rule holds true in the short term, at least. The value of a mutual fund investment is determined by its net asset value (NAV), which is the total market value of its entire portfolio divided, including any interest or dividends earned, by the number of shares outstanding. Because the NAV is based in part on the market value of the fund's assets, rising interest rates can have a serious impact on the NAV of a bond fund holding newly undesirable assets. If interest rates drop and older bonds begin trading at a premium, the NAV may jump significantly. For those looking to cash out mutual fund shares in the short term, interest rate changes can be either disastrous or delightful.

However, the life of a bond has a lot to do with how much of an effect interest rate changes have on its value. Bonds that are very near maturity, within a year for example, are much less likely to lose or gain value. This is because, at maturity, the bond issuer must pay the full par value of the bond to whoever owns it. As the maturity date approaches, the market value of a bond converges with its par value. Bonds that have many years left until maturity, conversely, can be greatly impacted by changing rates.

Because of the stability of short-term debt, money market funds or other mutual funds that invest primarily in secure, short-term assets issued by highly rated governments or corporations are less vulnerable to the ravages of interest rate volatility. Similarly, buy-and-hold investors who own shares in long-term bond funds may be able to ride out the roller coaster ride of interest rate fluctuations as the market value of the portfolio converges with its total par value over time. In addition, bond funds can purchase newer, higher-interest bonds as older assets mature.

The impact of changing interest rates is clear when it comes to the profitability of debt-oriented mutual funds. However, rising interest rates may make mutual funds, and other investments, less attractive in general. Because the cost of borrowing increases as interest rates rise, individuals and businesses have less money to put into their portfolios. This means mutual funds have less capital to work with, making it harder to generate healthy returns. In addition, the stock market tends to take a dip when interest rates increase, which hurts shareholders of both individual stocks and stock-holding mutual funds.