Using Debt Funds Opportunistically
The fluctuating prices of bonds can be used to enhance your portfolio's returns by investing in debt funds
Jan 31, 2017
Let's make it clear that the investing strategy described here is actually not for beginners. It's a fairly advanced approach to investing and is best suited to be implemented by professional investors.
The interest that is paid on their holdings is not the only source of income for debt funds. Most of the bonds that these funds invest in are also traded in a debt market, just as equity shares are traded on a stock market. Like anything traded on a market, the price of each bond can rise as well as fall. When the price of a bond rises, then that means additional gains for the investors of the mutual funds that have put money in that bond. The opposite is also true, when the price of a bond falls, then that the investors of the mutual funds that have put money in that bond are going to make smaller gains.
But why should the prices of bonds rise or fall. After all, the only source of income that flows into a bond is the interest paid on it, and this interest is fixed. Here's what actually happens. These price changes generally happen in response to a change in interest rates, or even the expectation of such a change. Suppose there's a bond that pays out interest at a rate of 9 per cent a year. Then, the interest rates in the economy fall and newer bonds start getting issued at 8 per cent. Obviously, the old bond should now be worth more than earlier. After all, a given amount of money invested in it can earn more money. Its price would now rise. Mutual funds that hold it would find their holdings worth more and they could make additional profits by selling this bond. Again, obviously, the reverse could happen when interest rates rise. Despite the expectation of safety, such a situation could actually result in some losses for a bond fund.
Moreover, the amount of rise or fall is proportionate to what is called the residual maturity of a debt fund. So what does it mean to 'Using Debt Funds Opportunistically', as our title puts it? That means to try and anticipate forthcoming changes in the levels of interest rate and then buy funds that will benefit from it. For example, as, there is widespread anticipation that the Reserve Bank of India will lower interest rates soon. If that happens, then the funds that hold bonds (specially government bonds) of long residual maturity will suddenly make good gains.
However, as we said up front, this is not really a beginners' technique. It involves having a correct idea of which way interest rates are heading and that's not everyone's cup of tea.