Today, income funds provide good returns. But in future, when they invest in government securities and bonds at lower rate than those available today, how will it affect the return on investment? Will mutual funds be able to compensate this over a long period?
—Madhusudan Arora
You have caught on to the big picture of declining interest rates and their effect on bond fund returns. As yields on bonds decrease (and prices increase), fund managers have a great time delivering astounding returns at a time when the interest (coupon) income is meagre. Obviously, trading profits are high and these more than compensate for lower interest income.
When funds invest in lower coupon bonds, their interest income will definitely be less. If interest rates do not continue to decline (i.e., prices do not rise), then trading profits will be negligible. In such a situation returns will be very close to the coupon income. Funds can try a number of things to boost returns in such a situation. One, they can invest in lower rated debt securities. These carry higher interest and can be used to boost returns. The lower rating, however, signifies higher risk and this will have to be kept in mind. Two, funds can invest a higher portion in government securities. As these securities are more liquid, trading opportunities are greater compared to corporate bonds, which are relatively illiquid. There is a trade-off here too. Government securities carry no default risk. Lower risk means lower returns and so these bonds carry lower coupon as compared to those issued by other borrowers in the market.
Through strategies such as those mentioned above a fund can try to boost returns. But there will be trade-offs in the form of the quality of the portfolio or increased volatility. And there is a limit to which a fund can exercise such options without changing the overall nature of the fund. So at the end of the day, one will have to reconcile with lower returns from bond funds.
This article was originally published on November 18, 2003.
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