What Should Debt Mutual Fund Investors do in a Falling Interest Rate Regime?

Central Bank increased the benchmark interest rates thirteen times to 8.50% between March 2010 and October 2011. The Central Bank reversed its stance and cut the benchmark repo rate by 50 bps in April 2012. Since then the Central Bank reduced the interest rate thrice (cumulatively by 75 bps) to 7.25%. The Central Bank cut interest rates following sluggish domestic growth rate and fall in inflation numbers. The Wholesale Price Index-based inflation stood at 41-month low in April 2013 while industrial output grew 1.0% in 2012-13 compared to 2.9% in 2011-12. In such a situation, long-term debt funds emerge as an appropriate investment tool as they deliver superior returns in a falling interest rate environment.

Bond prices rise with the fall in interest rates and vice versa. Long-term bonds are more sensitive to interest rate movements than short-term bond funds. This is because the net asset value (NAV) of the fund replicates the prices of the underlying securities. If the interest rate falls, the NAV of debt funds rise. Moreover, long-term debt funds would benefit more than short-term debt funds due to the longer maturity of the underlying securities held by the former. Short-term funds, whose portfolio contains securities with a shorter maturity, would see a lower price change because they are less sensitive to interest rate changes. Long-term debt funds basically include (i) Income funds that invest a majority of its corpus in Government Securities and Corporate Bonds with longer tenure and (ii) Gilt funds that invest in bonds issued by the Central Government and State Governments.

Here, Graph-1 represents returns of Income and Gilt funds compared with 10-year benchmark bonds from January 2006 to May 2013 and Graph-2 shows the returns of Liquid funds in comparison with commercial papers (CP) rates. During the period January 2006 to July 2008, when the interest rate was moving up the liquid funds on an average generated higher returns in comparison with the Income and Gilt funds. While same was reversed during the period of August 2008 to December 2009, when Central Bank cut benchmark interest rates from 9.00% to 4.75%. The income and gilt funds during the same period has generated average return of 9.37% and 8.97% while liquid funds generated 5.56% average return. The same scenario was also seen during the 2010-2011 period, when the interest rate moved up again. In November 2012- May 2013 period, when Central Bank has started easing the interest rates, Income and Gilt funds gave double-digit returns of 11.46% and 12.05% respectively while Liquid funds generated 8.52% average return. 

Before investing in any long term debt fund, one should look into the various factors like:

 Average Maturity – The average maturity of a debt mutual fund portfolio is the average of all securities that the fund constitutes. Long-term bonds (10 years or more) tend to be very vulnerable to inflation and usually deliver poor returns during inflationary periods. Thus it makes sense to invest in funds of higher average maturity when at the peak of the interest rate curve to make the maximum out of the falling interest rate scenario.

 Modified Duration - Duration is a measure of a debt fund’s sensitivity to changes in interest rates scenario. The lower the duration, the less volatile the fund will be. A modified duration of 5 means that a particular fund’s NAV would be expected to drop 5% for every 1% rise in interest rates (and vice versa).

 Yield to Maturity - Yield to Maturity (YTM) is the current interest rate a debt fund is earning from the holding of its constituents. Assuming that interest rate remains steady, YTM is also the expected annual return of the portfolio. Yield from the fund is the weighted average of yields of different securities, weighted by the proportion of sum invested in the fund (as a fund invests in bonds of varying maturities and yields). The weighted average yield gives an indication of the attractiveness of the underlying bonds invested by the fund. However, interest rate risks, possible defaults and reinvestment risks might affect the returns of a debt fund.

 Credit Quality - A retail investor must look at the detailed portfolio to see the credit rating of the papers in which the fund is investing. A lower credit rating signifies higher chances of default. Higher-quality investment grade bonds tend to offer slightly lower interest rates than lower-rated bonds, but also tend to have a much lower default rate.