What is the correlation between debt fund performance and interest rates?

Debt funds are basically a kind of fixed income investment instruments, where investment is done in a mix of debt or fixed income securities such as treasury bills, government securities, corporate bonds, and money market instruments. Basically, all these instruments in which a debt fund invests are capable of providing better returns than Fixed Deposits while ensuring that the investor is exposed to a very minimal amount of risk.

Co-Relation between interest rate and yield of bonds

Returns from debt mutual funds are influenced by various factors including, interest rates, inflation, currency fluctuations, current account deficit etc. The rate of return of fixed income securities also known as yield is calculated as the ratio of interest income from the security to the price ( face value ) at which it was bought. Any change in interest rates for that matter, leads to a subsequent change in the yield of the fixed income securities. When you buy a bond you are effectively lending your money to the issuer of the bond for a fixed period of time and at a fixed rate of interest. Let us consider that an entity issues a bond for 1000 Rs at an interest rate of 10% p.a. , now if there is a drop in interest rates in the market then the demand for previously issues securities which offer a higher rate of interest goes up. This time you will be able to sell it at a premium that is, the price of the security will go up but the interest income will remain the same therefore there will be a drop in the yield ( interest income/ price of the bond ). Similarly if there is an increase in rate of interest then the demand for securities issued at lower interest rates will go down and hence these securities will trade at a discounted price. Consequently the yield of such securities will rise following the same logic. 

Lately, we are observing that RBI is opting for a very accommodative monetary policy adding liquidity and reducing policy rates, although this bimonthly policy review kept the rates constant. An economic environment with low demand led to declining interest rates; while the government's historic decision of demonetization has channelized cash into the banking system. Evidently, surplus bank liquidity and low interest rates are here to stay. And therefore, if you become a bond holder now apparently you will be getting the previously issued securities at a premium price and therefore a reduced yield.

Attached are some of the debt funds that can be considered.

Debt Funds are funds which invest major portion of investments in debt of companies or fixed income securities or security bonds and earn from the interest the debt companies get. Debt funds are for those who want steady income at lower risks.

1. Let us understand relation between Debt Fund House and Companies which issue bonds to fund house by giving some particular rate of interest (also known as Coupon Rating).
2. Suppose 10 investors investing Rs.10000 each in Debt Fund House “A”. So total investment/money Debt Fund will have is 1lac and Debt Fund House A decided to invest in Company “B” for 2 years which issues Security Bonds at 10% Coupon Rate semi-annually.
3. So every 6 months B gives Rs.5000 as interest to A every six month.
4. Scenario 1) Suppose after 15 days from beginning, Coupon Rate increases to 15%, now original bond credibility decreases in the market. So if Debt Fund house want to sell bond, it will get less than the initial bond value(less than 1lac). So the performance of debt fund would impact (decreases).
5. But here another scenario comes into picture i.e. A will continue with bond for 2 years and get Rs.20000 (if investors continued for 2 years). But if investor wants to withdraw money they would get less than the actual amount they invested.
6. Scenario 2) Suppose after 15 days the Coupon rate decreases to 5%, now original bond credibility increases in the market. So if Debt Fund house  want to sell bond, it will get more than the initial bond value (greater than 1lac).
7. So the performance of debt fund would impact (increases). But here another scenario comes into picture i.e. A will continue with bond for 2 years and get Rs.20000 (if investors continued for 2 years) performance would be same but it can be improved by selling bond in between. Investors would get profit on amount they invested.

Debt funds are the types of mutual funds which invest capital of investors in bonds and deposits of various kinds and pass on the interest earned in the form of returns to the investors. In simple terms, investors lend money and earn interest (returns) on the money they have lent.

Debt mutual funds are ideal for investors who are risk averse and demand regular income from the investments. However, the returns from the debt are impacted by number of factors such as interest rates, currency exchange rates, inflation, current account deficit of the government, etc. Debt mutual funds invest in bonds and other fixed income securities issued by the businesses and government. Bond issues (borrower) pay interest to the investor at a specific rate (coupon rate) during certain intervals. The principal amount is paid at the end of the maturity period. The rate of return is referred to as yield rate.

Impact of interest rate on debt funds:

When we invest in FDs, the rate of interest is impacted by inflation. If the inflation rate is at par with deposit rate, it is not viable to invest in FDs. In the case of bonds, the price of bonds (or any other fixed income instrument) and the interest rate are inversely proportional. If the interest rate increases, the price of bonds decreases and vice versa.

For example, consider a government bond of 10 years having a face value of Rs. 1000 and a coupon rate of 8%. If the lending rate of these bonds increase to 10%, people will start selling existing bonds as it is providing less yield with respect to market and hence, the face value of price of the bond decreases. Now suppose the bond is traded at Rs. 900 which will result in a yield of 8.89% (80/900) to investor.

Similarly, if the interest rates are reduced to 7%, the coupon rate of existing bonds i.e. 8% will attract more investors and bonds will start getting traded at higher price.  A drop in interest rate creates more demand for the tradable existing bonds in the market.