Medium to long-term debt funds lucrative as interest rates fall

In the last few months, as the Reserve Bank of India went on cutting rates, went on cutting rates, mostly surprising market players with mid-policy decisions on rates, debt funds with longer duration came into the limelight. This is because in a falling interest rate scenario, medium and longterm debt funds stand to gain from capital appreciation. As yields fall because of the lower rate of interest in the economy, prices of bonds would rise which, in turn, would lead to capital appreciation for the funds holding bonds with maturities of 1,2,3...years. Change in the rate of interest, however, usually does not lead to much price appreciation for bonds of shorter duration.
In the mutual fund industry, usually debt funds which aim to take money from investors who have an investment horizon of between one and three years are categorised as medium-term funds. On the other hand, those funds which aim to take in investors with a horizon of more than three years are categorised as longterm debt funds. Fund industry officials say about 15-20% of one's debt portfolio should be invested in medium-term funds which take credit calls as well as duration calls. Credit calls are betting on those bonds which have lower than `AAA' rating on the hopes that these bonds, over the next 2-3 years, will improve their credit ratings, leading to price appreciation.
Usually, these funds invest in AAA rated bonds and also some part into bonds rated lower, but do not invest in debt instruments with credit ratings lower than AA."There is no junk play in these funds," said a top official at a domestic fund house.
On the other hand, a duration call is betting on the fact that the rate of interest in the economy will fall, leading to price appreciation. "These funds are usually more aggressive in nature and have the potential for good YTM (yield-to-maturity) for investors with up to three years investment horizon," the of ficial said.
In these funds, the fund managers invest in bonds of good companies which, as the economy improves, are likely to do better than the economy in general and, hence, could improve its credit rating. In addition, if the rate of interest in the economy falls, prices of these bonds will also rise because of falling yield, which in turn would lead to capital appreciation. And, hence, the gains in these funds could be two-fold.
Bond yields and prices are inversely related
Bond yields and price are inversely related. Here's why. Assume the annual rate of interest on a bond is 10% and its price when offered to the public for the first time is Rs 100. So all those people who hold the bonds for a year will receive Rs 10 at the end of the year. If over the one year after allotment, the price of the bond steadily rises to Rs 110. At the end of the first year, the original investor takes Rs 10 (interest income) and then sells the bond at Rs 110. The second holder will get Rs 10 at the end of the second year. However, for the second holder the interest income at the end of the second year will be Rs 10 on an investment of Rs 110.So, for this person, the yield (interest income as a percentage of the price paid) works out to approximately 9.1%. So here a rise in the price leads to a fall in bond yield.
Inversely, if the price of the same band falls to Rs 90 at the end of the first year and is sold to another buyer who holds it for a year and receives Rs 10, the yield for the second holder will be approximately 11.11%. In the second case, the fall in bond prices led to higher yield.