The Unexpected Happenings

Last week, debt fund of all kind generated the most amazing returns for their investors. According to a Value Research analysis, for about 60 per cent of the debt funds, the 30 days ending around 18th December have been their best month ever. In fact, so strong has this performance been that the 90 days ending on that date have been these funds' best quarter ever and the year ending on that date has been their best year ever.

This is an amazing bonanza. Over these days, there are funds that have gained a decidedly equity-like 8 to 10 per cent. There are as many as 50 funds that have gained more than six per cent over just a week's time. These are the kind of returns that debt investors expect over many months, perhaps a whole year. The source of this bonanza is the precipitous drop in interest rates that the Reserve Bank has engineered in order to kick-start economic activity that has slumped.

While these returns are more than welcome to fund investors in these troubled times, they do point to the fact that debt fund investing has entered a more volatile phase than it has been in for at least half-a-decade. As the central bank tries to juggle between high inflation and low (or negative) growth by manipulating the cost of borrowings, debt fund returns are going to be volatile.

However, first things first. Many new 'non-professional' debt fund investors don't clearly understand why debt fund returns should react so violently to interest rate changes so let me recap the basics here. Debt funds invest in bonds issued by the government and by companies. These bonds represent a fixed income stream that consists of a periodic interest payment and a final repayment when the bond is redeemed. However, the bonds are also traded and the market for such trading is quite active at least as far as government bonds is concerned. The market value of these bonds fluctuates in reaction to (and of course, in anticipation of) changes in interest rates that the central bank mandates.

Why should that be so? Simply because when interest rates fall, bonds issued earlier at higher interest rates become more desirable and their market price increases. The opposite happens when interest rates rise. Also, the magnitude by which the market price of a bond reacts to rate changes depends on how far in the future a bond's redemption lies. Those funds which are mandated to avoid volatility stick to short-term bonds. It is these market prices of bonds that are used to calculate the NAVs and returns of mutual funds which invest in them. What has happened recently is a quick fall in interest rates that has led to sharply higher prices for bonds. Fund managers who anticipated the rate crash and moved into longer-term bonds have reaped fatter rewards.

However, interest rate volatility is a double-edged sword. Two months down the line, if the RBI finds that growth worries were overstated and the spectre of inflation looms again (perhaps oil prices will start rising again), then the opposite part of the cycle could suddenly set in. As I said earlier, returns depend on how well a particular fund manager anticipates what is going to happen.

For investors who seek out debt funds for safety and stability, shorter-term debt funds should be the only choice in the months to come. However, when the equity markets are in a diffident mood, a sharply-run debt fund can generate very handy returns indeed.