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How do interest rates affect debt funds?

Dhirendra Kumar explains how fluctuations in interest rates affect the returns from debt funds

How is return from debt funds related to interest rate?
- C Kumar

The linkage of interest rates to debt funds is actually on two fronts and investors should understand very intimately how it works. A bond fund is nothing but a bunch of bonds. When interest rates go up, the return from new bonds that will be issued or which a fund will invest in, will be higher. That is why the bond prices of those bonds held by the existing bond fund go down in value.

The opposite happens when interest rates go down. The fund will continue to get higher interest on the prevailing bonds that it holds which yield say 10 per cent. And if it comes down to nine per cent, the bond prices which your fund owns, will go up in value because they will continue to benefit from higher interest rates till the expiry of those bonds which are held by them. So there is an inverse relationship.

Those bonds which have longer maturity tend to benefit more when interest rates go down and they are also hurt more when interest rates go up. Apart from this one-time event, as and when interest rate changes or the outlook for interest rate changes, there is an impact on the bond fund. If interest rates fluctuate, then the current yield on the existing bonds will also change.

So bond funds actually get two things, one is the appreciation or depreciation on the bond that they hold and second, the interest payment that accrues on those bonds, whether it be annually, semi-annually or quarterly depending on the term. The interest rate which the bond fund gets can come down or go up depending on the prevailing interest rates. So by and large, there's a one-time impact and then there is a continuing running impact depending on the interest rate.

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