Understand Most Important Concept of Debt Funds

22 Aug Understand Most Important Concept of Debt Funds

1. Understanding the most difficult formula of Debt Funds

Most are confused by the Debt Funds formula that “When interest rates rise debt funds NAV drops and when interest rates fall debt funds NAV rise”.

How this happens perplexes most.

As they say Ghee jab seedhi ungli se nahi nikalti toh use tedhi ungli se nikalni padti hai.

So let’s understand this debt fund NAV relationship through an analogy.

Let’s say two friends Ram & Shyam take up similar jobs. The only difference is Ram’s job has him to sign up a bond or agreement of serving for at least 2 years while Shyam’s has it for a mere 5 months.

Both like their jobs and they work diligently.

However,  2 months later an amazing opportunity arises by way of another “job offer” paying double the salary they are currently drawing.

Now what do you think will happen to sentiments of Ram and Shyam.

Remember Ram has a 2 years contract / bond and only 2 months have elapsed.

Shyam on the other hand has a 5 months bond / contract  which is just 3 months away.

If there was an NAV that represented Positive & Negative sentiments what do you think would happen to the NAV of Ram and NAV of Shyam.

Ram would be extremely upset as he is bonded to his job for another 22 months and has no option but to let go the greatest offer of his life. His NAV representing his sentiments would drop significantly.

Shyam on the other hand has just 3 months for his bond/contract/agreement to expire and he believes he will be able to to grab the greatest offer of his life. He would be a little anxious because of the 3 months that he would have to manage but because 3 months isn’t that long a period his Happiness NAV would not be adversely affected.

This is exactly what happens in debt funds having either long duration or short duration investment papers when interest rates rise.

Rising interest rate is an opportunity to migrate to a higher yielding paper.

The long duration fund does not have an escape route and hence its NAV falls while the short duration fund has an exit route round the corner. Hence it’s NAV is less impacted.

Therefore when one is expecting interest rates to go up, one must move from long duration Corporate Bond Funds and Banking and PSU Bond Funds to Low Duration Funds.

Hope this explanation once for all puts at rest every confusion that arises out of the blindly followed formula “If Interest Rates go up NAV comes down and If Interest Rates come down NAV goes up”