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Falling interest good for long-term debt funds

However, with timing of rate cuts uncertain, check potential of short-term funds as well

Priya Nair  |  Mumbai 

A fall in interest rates is bad news for bank depositors. But it is not necessarily so for investors in long-term debt funds. While debt funds would also see a fall in their yields when interest rates fall, there is a corresponding rise in their prices, because bond yields and prices are inversely proportional.

Debt funds gain when interest rates rise by way of interest accrual. They also gain when interest rates fall by way of capital appreciation.

Since August, the yield on the benchmark 10-year government security has fallen from 8.25 per cent to 8.14 per cent in October and price has increased from Rs 99.5 to Rs 100.10. With all indications of further cuts in interest rates by the Reserve Bank of India (RBI), it is possible that bond yields may fall, going ahead.

The website Investopedia defines modified duration as a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. This formula is used to determine the effect that a 100-basis-point (one percentage) change in interest rates will have on the price of a bond. 
In other words, modified duration indicates the interest rate sensitivity of the fund. If you invest in a higher-duration fund, any interest rate cut will increase the value of your portfolio.
Modified duration of income funds
Modified Duration
Birla Sun Life Income Plus 6.28
HDFC Income 5.91
SBI Dynamic Bond 5.47
ICICI Prudential Income 5.39
Sundaram Bond Saver 4.90
Source: Value Research              Illustration: Ajay Mohanty

“Over the next nine months, gilt funds and corporate bond funds are likely to gain as there is every possibility that the RBI will cut interest rates,” says Amar Ranu, associate vice-president (third party products), Motilal Oswal Private Wealth, adding that investors can look at funds, which have a modified duration.

For every one per cent fall in interest rates, the portfolio value of the fund would increase by its modified duration. For instance, if the modified duration of a fund is six and if interest rate falls by one per cent, then the portfolio value will go up by six per cent.

The modified duration of the fund is mentioned in the fact sheets that are released by mutual funds every month. If investors are sure that interest rates are likely to come down, then they must select long duration funds, such as income funds, dynamic bond funds or gilt funds, says Ganti Murthy, senior vice-president and head, fixed income, Peerless Mutual Fund.

“By virtue of being long duration, these funds will give higher returns when interest rates fall as there will be capital gains,” he says.

On the other hand, those who are looking only for interest accruals, but not so much capital gains can go for short duration funds. Short-term bond funds, which invest mostly in securities of six months to one year work on accrual basis. In such funds, the fund manager hardly churns the portfolio because the maturity of the underlying investment is not very high. So, there will be no benefit of the falling interest rates.

According to Rajesh Krishnamoorthy, managing director, iFast Financial, interest rates are expected to move in a southward direction. Although improvement in banking system liquidity and a cut in the cash reserve ratio have eased short-term rates, lower credit demand is pushing up the demand for government securities.

However, the timing of a rate cut is not certain due to the high inflation. In such a scenario, short-term funds will be an appropriate option for investment. Longer-term investors can also look at dynamic bond funds.

“We are suggesting funds where we see that the portfolios are running good current yields (accruals) and not taking too much of a longer term position (duration risk). By looking at these funds, investors can benefit as the current yields are high and in the event of an interest rate cut, there is an upside for the bond prices to go up leading to some capital appreciation contributing to the overall returns,” Krishnamoorthy says.

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First Published: Fri, October 05 2012. 00:51 IST