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How interest rate fluctuation impacts debt mutual funds?

Debt oriented mutual funds are often preferred investment vehicles for risk averse and conservative investors. The returns from the debt mutual funds are influenced by several factors like interest rates, currency fluctuations, inflation rates, and current account deficit of the government, and credit risk. The debt mutual funds invest in fixed income securities issued by government and businesses. The issuer of a fixed income security (bond) pays interest at a specified rate (coupon rate) and specified intervals. The principal is repaid at the maturity rate. The rate of return on the investment in fixed income terminology is referred as yield. The yield on a fixed income security is calculated as the ratio of interest received on the fixed income security and the price at which it was bought.

Bond markets and its dependency on interest rates

The prices of fixed income securities are governed by the interest rates prevailing in the market. Interest rates and prices of fixed income securities are inversely proportional. If the interest rates increase from the current level, the prices of fixed income securities decrease. Similarly, if the interest rates decrease, the prices of fixed income securities increase.

For example, consider a 10 year government bond which has a face value of 1000 a coupon rate of 8% i.e. one receives an interest payment of 80. If the lending rate has been increased to 10%, the new bonds with the same face value of 1000 and tenure of 10 years provide a coupon rate of 10%. This makes the existing bonds at 8% coupon rate less attractive and it will be traded below its face value in the market. Let us assume that the existing bond is now being traded at 900. The yield of the bond is increased to 8.89% (80/900 *100) from the initial 8%.

Similarly, if the interest rates are slashed to 7%, the existing bonds at 8% coupon rate attract more buyers. Now the bond trades at price higher than its face value. If the bond the trades at 1050, the yield on the bond will be 7.62% which is lower compared to the initial rate of 8%.  The yield of the bond maintains a direct relation with interest rate and the price of the bonds maintain an inverse relation. A drop in interest rates will create more demand for existing bonds in the secondary market and increases the bond price. Similarly, when the interest rates increase, the existing bonds are traded below their face value.

Debt Mutual fund returns and Interest Rates

Governments and Businesses raise capital by accessing the fixed income markets. To be able to attract the buyers, the bond issuers have to give competitive yields on the fixed income instruments. Such bonds issued by governments and businesses are not often open for individuals. Mutual funds houses can buy these bonds. So essentially, a subscriber to a debt mutual fund is indirectly investing in these bonds through the mutual fund house. The Net Asset Value (NAV) of such mutual funds is calculated as a sum of price of the bond and coupon payments (interest accrued). Since these funds are traded in secondary markets, the interest accrued is calculated on a daily basis to realize the accurate NAV of the fund. The NAV of debt funds varies with the prices of bonds they hold and interest being accrued on them. Since the prices of the bonds are governed by the interest rates, a change in the interest rate is reflected in the NAV of the debt fund. The NAVs of the debt mutual fund hold the same inverse relation with interest rates. The NAVs of debt funds are recorded lower when the interest rates increase and the NAVs increase if the interest rates decrease.

Debt Investment Strategy during current course of events

Debt markets provided good returns in the previous year on the back of interest rate cuts implemented by RBI. However, in order to stabilize the volatile rupee and curb its downward movement, RBI has recently announced the measures to tighten the liquidity and hiked lending rates for banks. This caused a panic in the debt markets and markets faced a huge sell off pressure. It is important that one does not panic and liquidate the debt investments during current course of events. Considering the current state of Indian Economy, the move by RBI came as surprise for the debt markets. In order to revive the economy, it is important for the government to revive the investment cycle. The investment cycle should be well supported by the interest rate cuts by the government. Once the volatility of the rupee subsides and its slide is arrested, government is expected to kick back the interest rate cut cycle. So staying invested for longer time is advisable over booking losses by selling the debt investments in the current scenario. If you are planning to buy debt funds, choose the duration of the fund based on your risk appetite.

- Nitin Vyakaranam
(The author is the Founder & CEO of ArthaYantra.com)

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