Why you should buy Long Term Debt Funds?

Long Term Debt Funds will deliver Double Digit Returns reads the headline on popular finance portal. This is one of the examples, In last 3-4 months, you must have come across similar headlines multiple times if you are a regular investor. At max, the reason given was that with the drop in Interest rates, Bond yield will drop which will increase the Bond Prices. In short, Drop in Interest Rate will benefit the Long Term Debt Funds the most as they invest in Government of India Bonds and Corporate Bonds of long term maturity. Though there is no standard definition of Long Term Debt Funds but in my opinion any debt fund with Average Maturity of more than 10 years can be safely termed as Long Term Debt Funds. These funds are normally benchmarked against the G-Sec yield of 10 years or Govt of India Bonds. As of today, the yield of 10 year G-Sec / Bond is 7.799%.

Movement of Average maturity of debt fund gives the fair idea how the interest rates will move in near future. In last 6 months, the average maturity of almost all Long Term Debt Funds, Dynamic Bonds and Income Funds have increased considerably. Average Maturity of the best performing fund in this category i.e. ICICI Prudential Long Term Fund is now 19 years. 6 months back it was around 11 years. IDFC Dynamic Bond fund which is consistently rated as “Consistent Performer – Debt Funds” in CRISIL Mutual fund ratings, Average Maturity is now 15.39 years. It clearly implies that Industry is anticipating further rate cuts by RBI to fuel growth in the economy. Any rate cut will result in lower Bond yield. Lower Bond yield will increase the Bond Price, therefore, these mutual funds may deliver double digit return. If you invest in right debt funds then you can always beat the returns of traditional popular debt instruments like Fixed Deposits, Recurring Deposit, Post Office Savings Schemes etc.

Co-relation between Bond Yield and Bond Price

Before you invest in Long Term Debt Funds, you should understand the concept and co-relation between Bond Yield and Bond Price. Though in all the posts it was mentioned that with the cut in the interest rate, Bond yield will drop thus it will increase Bond Price. This relation can defined in 2 ways which don’t have any co-relation with each other. One is the scientific justification and another is Sentiments i.e. Demand and Supply theory.

Though these calculations are very complex but let’s understand with an easy and simple example. Assuming Long Term Debt Funds bought a Bond A of Rs 1000 with the maturity of 10 years at the coupon rate of 9%. In this case, Bond Price is Rs 1000 and Average Maturity is 10 Years. The Bond yield is 9%. If there is no change and status quo is maintained then these 3 data points will remain the same. The fund house will happily receive Rs 90 i.e. 9% of Rs 1000 as an annual returns. The average return of Long Term Debt Funds will be fixed 9%. The real game begins when interest rate either increase or decrease. Let’s check what will be impact on Long Term Debt Funds in these 2 scenarios

(i) Interest Rates Increase: Now assume that RBI increased Repo rate and Interest Rates are now 10%. In this case, fund house will still get Rs 90 as an annual return but as the interest rate is 10% therefore Bond Price will drop to Rs 900 i.e. absolute return will remain fixed at Rs 90 only but now this Rs 90 should be 10% of Bond Price to adjust the Bond Price. Therefore, reverse calculations fix the Bond Price at Rs 900. The investor will lose in this scenario as the value of his bond is now Rs 900 whereas he bought for Rs 1000. Let’s check why the price of a Bond A dropped by Rs 100. Let say, the mutual fund house buys another Bond B after interest rate increased (Offered after interest rate increase). The Coupon Rate is now 10% and Bond Price is  Rs 1000. The maturity of Bond is 10 years. In this case, fund house will get Rs 100 as an annual return whereas in Bond A, the fund house is earning Rs 90 only. Face value or Bond Price of both the Bonds i.e. Bond A and Bond B is Rs 1000. But Bond A will return Rs 90 and Bond B will return Rs 100. In case of status quo, For 10 years Bond A will return Rs 100 less than Bond B therefore price of Bond A is now Rs 100 less than Price of Bond B. To conclude, in case of Long Term Debt Funds if the interest rate increase then the returns drop. It can be negative also depending on the fluctuations in the interest rate cycle. In this example, we considered Bond for simplicity purpose but same co-relation exists in G-Sec yields of different maturities.

Secondly, on sentiment front the demand of Bond A will not be there if price is more than Rs 900 because the investor will buy Bond B with the higher yield at 10%. At Rs 900, the yield of Bond A is not adjusted as per market condition. Therefore besides scientific calculations, sentiments will also pull down the price of Bond A to Rs 900. If there is further anticipation of an increase in interest rates then Bond A will take further beating and may trade below Rs 900.

In this scenario, Long Term Debt Funds will decrease Average Maturity as the instruments with short maturity will gain maximum from the increase in interest rate.

To conclude, Bond Price is adjusted according to the current yield. Bond price will drop if the current yield is more than the yield of Bond and vice versa. Let’s understand what will happen when Interest Rate decrease which is the current scenario.

(i) Interest Rates Decrease: Currently interest rates are decreasing. RBI has cut the Repo rate twice by 0.25% each. In this same example of Bond A. Assume, Interest Rates are now 8%. The fund house will still get Rs 90 as an annual return on Bond A. Bond Price will be adjusted to the extent that this Rs 90 is 8% of Bond Price. Therefore, Bond Price will increase from Rs 1000 to Rs 1125. The Bond will be traded at a premium of Rs 125 i.e. 12.5%. The NAV of Long Term Debt Funds will increase to the same extent. Again let’s assume that Long Term Debt Funds buy another Bond C after interest rates are decreased. Bond Price of Bond C is same Rs 1000 and Coupon Rate is 8%. Assuming same maturity of 10 years, annual return from Bond C will be Rs 80 against Rs 90 of Bond A. In this case, compared to Bond C there will be more demand for Bond A and market sentiments will pull the price to around Rs 1125 till the Bond yield is adjusted to 8% i.e. at current rate. Long Term Debt Funds which bought Bond A at face value will get the double advantage of higher yield and appreciation in Bond Price. In Short, Long Term Debt Funds which bought at Rs 1000 will gain maximum in this scenario.

Long Term Debt Funds

As it is always mention that before you invest in any financial instrument, it is advisable to understand how to it works. In the current scenario, you can invest in Long Term Debt Funds and stay invested for next 24 months to 30 months till interest rates are dropping. The advantage of understanding the investment philosophy before investment is that it signals when is the right time to exit.

If you are risk averse investor then very simple philosophy is to invest in Long Term Debt Funds when interest rates are falling. You may shift your investment to short term mutual funds when the interest rates start increasing. Another option is to invest in Dynamic Bond Funds as they change investment strategy with interest cycle. Following are some of the Long Term Debt Funds suggestion from my end. 

1. ICICI Prudential Long Term Fund – Regular Plan (Average Maturity: 19.05 years)

2. Birla Sunlife Dynamic Bond Fund – Retail (Average Maturity: NA, roughly near 10 years)

3. IDFC Dynamic Bond Fund – Regular Plan (Average Maturity: 15.93 years)

4. DSP BlackRock Strategic Bond Fund – Institutional Plan (Average Maturity: 11.60 years)

5. UTI Dynamic Bond Fund (Average Maturity: 13.63 years)

Disclaimer: You must have observed that Dynamic Bond are preferable funds compared to pure Long Term Debt Funds. The reason being, Dynamic Bond Funds are flexible in nature as they increase the Average Maturity when interest rates fall and accordingly decrease the maturity when interest rates start increasing. Currently, Dynamic Bond Funds are like Long Term Debt Funds for me. You don’t need to actively manage these funds. To hedge risk, Average Maturity of portfolio ranges from 10 years to 20 years.

Long Term Debt Funds are Risk Free

Now you must be wondering we discussed price fluctuations of Bond Price and if interest rate fall then they may give heart attack and now they are Risk Free…That’s correct, Long Term Debt Funds are risk free because price fluctuations are normal during the interest rate cycle. The principal invested in risk free in Long Term Debt Funds. At the time of maturity, Principal amount i.e. Bond Price is redeemed to the investor. In short, if the investor or Long Term Debt Funds held the bond for 10 years then Rs 1000 will be redeemed irrespective of current Bond Price. Only fluctuation is in returns, but the principal is safe and secure.

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