Debt Funds and Interest Rate: Managing the Swing
A debt fund is a type of mutual fund that invests in fixed income securities such as bonds, treasury bills, corporate debentures, money market instruments and other debt instruments. The main objective of a debt fund is to provide regular income to investors and preserve their capital.
How Interest rates movement affects the performance of Debt Funds in the economy?
The prices of existing bonds have an inverse relationship with interest rates. When interest rates rise, the prices of existing bonds tend to fall, and when interest rates fall, bond prices tend to rise.
• Impact on Debt Fund NAV: As debt funds hold a portfolio of bonds, changes in interest rates affect the Net Asset Value (NAV) of the fund. If interest rates rise, the NAV of the debt fund may decrease, and if interest rates fall, the NAV may increase.
• Duration: One way to measure the interest rate risk of a debt fund is through its duration. Duration is a measure of the sensitivity of the bond prices in the fund’s portfolio to changes in interest rates. Higher duration implies higher interest rate risk.
Long-term debt funds with higher duration are more sensitive to interest rate movements than short-term funds.
• Credit Quality: Apart from interest rates, credit risk (risk of default by issuers) also affects debt fund returns. Economic conditions can impact credit quality and, consequently, the performance of debt funds.
What should you do in the event of interest rate rise and fall?
In anticipation of rate changes, investors often try to anticipate changes in interest rates and adjust their debt fund holdings accordingly. For example, if they expect rates to rise, they may shift to short-term funds to minimize interest rate risk.
Below mentioned table is a summary of different interest scenarios and the Debt Funds which tend to give perform better:
| When interest rate goes up | When interest rate goes down | No or less impact |
|---|---|---|
| Liquid, Ultrashort duration, Low duration and money market (can give better results) | Short Term, Medium Term, Gilt, Floater, Dynamic Bonds | Overnight Funds |