There
are some things that can confuse even seasoned equity investors. One of these
things is the link between debt funds and the interest rate cycle. Let's
start at the beginning.
First, what is a debt fund?
A debt
fund is nothing but a pool of investments (also known as a mutual fund) in
which the core portfolio comprises fixed income investments. These would be a
mix of short, medium or long term bonds, money market instruments, securitized
products and floating rate debt.
Bonds
(also called fixed income securities) are used by a variety of entities
such as corporate, municipalities and even the Government, to finance
activities. When you buy a bond, you are effectively lending money to this
entity that borrows your funds for a fixed time period and pays you a
pre-decided rate of interest at regular intervals, also pre-decided. This
interest is called a Coupon. Bonds are also traded in the secondary market
before they reach maturity, and each bond has a price that fluctuates depending
on market factors.
Given
that bond prices fluctuate, it is unlikely that you would ever buy a bond on
the secondary market "at par," or at its exact face value. You would
either buy below par i.e. at a discount, or above par i.e. at a premium.
Now that we know what coupon, price, and discount and
premium are, what is yield (to maturity)?
Yield
to Maturity (YTM) represents the total return you can expect to earn if you buy
a bond at a certain price and hold it till it matures, earning all the coupons
(or regular interest payouts) on the way too.
A
simpler version of this is just Current Yield. If you buy a bond "at
par", the yield is simply the Coupon. But if you by a bond where the price
is fluctuating, your yield will also fluctuate depending on how expensive (or
not) your bond is. This Yield is equal to nothing but Coupon divided by Price.
So current yield = Coupon / Price
Now that you've understood the relation between yields
and prices, in which situation would you want high yields and in which
situation would you want high prices?
You
would want high yields (i.e. low prices) when you are looking to buy a bond.
The adage Buy Low, Sell High applies here too. Once you have already bought the
bond and become a bondholder, you want high prices so that you can sell at
maximum gain.
So knowing this, when is a good time to become a
bondholder?
When
you know that yields are going to go down, going forward and therefore prices
of existing bonds are going to go up which will enable you, the bondholder, to
make maximum gain when your bond matures, or when you sell. This is what's
happening in our economy at the moment…
We are currently in a falling interest rate cycle.
When
interest rates in the economy (the repo and reverse repo rate) begin to fall,
new bonds will offer interest (coupon, to the bondholder) in line with the new,
lower rates of interest. This means that their coupon will be lower, so their
yield will be lower than the coupon and yield of existing bonds. Older bonds
that were issued in times of higher interest rates, would be offering higher
coupons and therefore comparatively higher yields. So these existing
bonds therefore become comparatively more attractive than newer bonds. People
are therefore willing to pay a premium to own these bonds. So when yields fall,
prices of existing bonds go up. It's simply a question of demand and supply.
And that's when debt funds make money, when the bonds in their portfolios
start to command higher prices, in times of falling interest rates.
How does this affect your finances? Should you be
adding to your debt portfolio currently?
To
answer the second question first, yes you should be adding to your debt
exposure if you have a lower risk appetite, a shorter time horizon (up to 3
years) and want to increase your debt portfolio exposure, to balance your
equity portfolio you should invest in short and medium income funds. Keep your
liquidity requirements in mind and also have an estimate of what post-tax
return you can expect (debt funds long term gains are taxed at 10% without
indexation or 20% with indexation).
Coming
to the first question, remember, debt funds are great investment avenues to
help you meet your short term life goals and also to contribute towards a
corpus for your longer term life goals. So if you are looking to build a debt
portfolio, now is a great time to do it.
