Impact of volatile Interest Rates on Debt Mutual Funds

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In the past few months, on the back of rising crude oil and the depreciating currency, there has been a spurt in market interest rates which spooked many debt fund investors. The historical returns on investment done in the period of the last 18 months have been showing unimpressive returns leading to disappointments. The 10-year Govt. bond yield is up from 6.5% in early 2017 to 8.15% now in a very short span of time.


Interest Rates

Source: Bloomberg.com

This sharp movement of interest rates on the upside results in mark-to-market losses which are notional. Vice versa, a sharp decline in market interest rates results in mark-to-market gain which is again notional in reality.

How mark-to-market affect portfolio returns?

Debt mutual fund is a tricky area. Contrary to the popular perception, it is more complex to understand than equity market especially due to mark-to-market component.

Imagine you have bought a debt paper with a purchasing price of ₹ 1000 (and the same face value of ₹ 1000), a tenure of 3 years and promises 8% coupon rate per annum. Also, let’s assume the “market” interest rate for similar debt papers is 8% at the time of buying the debt paper. This means you will get ₹ 80 every year for the next 3 years and ₹ 1000 at the end of the tenure of 3 years.

After a year, you will be holding a debt paper with 8% coupon rate and remaining term of 2 years. Now imagine, after 1 year the “market” interest rate for a similar debt paper with 2-year tenure increases to 10%. Do you think anyone will buy the debt paper at ₹ 1000 from you which is offering a coupon of ₹ 80 p.a. when another debt paper in the market with similar attributes is now offering a coupon of ₹ 100 p.a. for a purchasing price of ₹ 1000? The answer is definitely NO. 

However, in order to sell the paper that you are holding, you will have to reduce its selling price from  ₹ 1000 to ₹ 965, so that coupon of ₹ 80 for the remaining two years and the return of face value of ₹ 1000 after 2 years would result in a net yield of 10%. This fall in the value of debt paper from ₹ 1000 to ₹ 965 is called mark-to-market. That means the coupon you earned in the first year of ₹ 80 minus market-to-market loss of ₹ 35 (₹ 1000 minus ₹ 965) leads to the net gain of ₹ 45. This gain of 45 will appear as just a 4.5% return (over the purchase price of ₹ 1000) in the last one year against the initial expectation of ₹ 8%. 

However, if you continue to hold your debt paper for 3 years, you will receive the promised ₹ 80 per annum and a face value of ₹ 1000 at the time of maturity. So in reality, nothing changed from what was promised (8% interest rate) in the beginning. It’s only mark-to-market effect that misleads you in believing that your debt paper generated lower returns than your FDs. 

Similarly, when the “market” interest rates fall after you have purchased a debt paper, there would be a mark-to-market gain. This gain is also notional as you will get the same coupon and face value at the end of the tenure as promised originally. 

Value of debt paper is inversely proportional to “market” interest rates:

                                  debt Mutual fund               

Debt mutual funds hold many such debt papers of Government and corporate of different maturity and rating. They get affected by daily changes in market interest rates as they have to mark their holdings to market according to the SEBI mandate. 

What to do in a volatile interest rates scenario?

First of all, it is essential to select a debt mutual fund portfolio with an average maturity in line with your holding period and expected interest rate scenario. If you observe lower historical returns due to mark-to-market impact, continue holding you debt funds without any worry. Rather, it would be advisable to invest more when markets are offering higher yield compared to the levels when you invested. 

Higher the average maturity of a debt mutual fund, higher would be the mark-to-market impact. So in a rising interest rate scenario, a lower maturity debt fund would be preferable. On the other hand, in a falling interest rate scenario, a higher maturity debt fund would be preferable. 

Fortunately, your fixed deposits are not marked to market, else they will also show similar fluctuating returns during the period of holding while impacting nothing to your promised interest income and the principal. 

We hope this article made you wise regarding debt mutual fund investment. For more queries, please ask us in the comment section below.

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