How are returns from debt funds related to the interest rate?
-Naveen
It's a very basic question and this is something which most of the fixed deposit investors are surprised to hear.
When interest rates go up, bond prices fall. Bond prices fall because, if you invest fresh money in a new bond, then it will get a higher return. So all the bonds are priced lower to match with the higher return which prevails in the economic system. So there is an inverse relationship. Interest rates go up, bond prices fall. And when bond prices fall, bond funds also fall because they own those bonds. Similarly, the reverse is also true. Interest rates go down, these bond prices go up. So open-end bond funds benefit when interest rates go down. But this is a short-term thing.
Valuation with bonds is fairly arithmetic and very predictable. You simply discount the future cash flows. They are not like equity. There are just three things with bonds. How good it is, how much interest rate is it paying and what is the term. These three things fit into a formula which determines the valuation. So when interest rates go up or down, bond prices change in a fairly predictable and arithmetic manner.
This article was originally published on October 01, 2018.
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