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Why you should buy Long Term Debt Funds?

Debt Funds
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. I read almost all such articles, but none of the articles answered Why i should buy Long Term Debt Funds?. 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. As i track these funds, 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 i 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. The criterion of shortlisting following funds is same as i shared in my post 7 Steps to select Right Mutual Fund

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: I am invested in all the above mentioned 5 long term funds. You must have observed that i am preferring Dynamic Bond 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 i am saying 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.

Hope you liked the post…Happy Investing !!!

Copyright © Nitin Bhatia. All Rights Reserved.

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PK
PK
9 years ago

Hi Nitin,

Could You Please share some insights on pros/cons of opting for NPS(national Pension Scheme) & SAF

Nitin Bhatia
Nitin Bhatia
9 years ago
Reply to  PK

At macro level i will not suggest NPS (National Pension Scheme). I will share detailed post on same.

Deepak Jaju
Deepak Jaju
7 years ago
Reply to  Nitin Bhatia

I didn’t found detailed post on NPS from you

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  Deepak Jaju

There are large no changes in NPS rules and regulations. I will share a post with revised guidelines shortly.

Sunil
Sunil
9 years ago

Hi Nitin

Thanks for all the info on each and every topic……… was continuously reading for hours in your blog….. from past three days…. can’t believe that i read for 23 hrs in 3 days

My query is i’ve some Old mutual funds which took by my dad in 1993 in my dads name

I would like to know how to redeem/claim those now. Do my dad need to open Demat for selling those physical mutual fund bonds. else please let me know whom to contact for claiming money this old mutual funds.?

One more question is One of my mutual fund is not at all listing now. not sure which name it is now or stopped the fund not sure. Please help me out in this regard.

Here are my mutual funds :

SBI magnum multiplier plus 1993 – 200 shares

UTI MAster growth 1993 – 200 Shares.

Waiting for your reply.

Nitin Bhatia
Nitin Bhatia
9 years ago
Reply to  Sunil

I have not seen the statements but as i understand SBI magnum multiplier plus 1993 is now known as SBI Magnum Multiplier Fund. UTI Master growth 1993 is now known as UTI Top 100 Fund. Both the funds are doing good. You may retain the same.

To redeem the same you can approach the respective AMC. It is not compulsory to open demat account.

Udayakumar Palani
Udayakumar Palani
8 years ago

Dear Sir,
Thanks for the wonderful post.
I got confused in the last paragraph -“if the investor of Long Term Debt Funds held the bond for 10 years then Rs 1000 will be redeemed irrespective of current Bond Price”. How?

When the interest rate increases then the price of bond decreases to 900. Then how the principal will be redeemed for Rs.1000?

In the same way if the interest rate decreases then the price increases to 1125. Then during maturity it should be redeemed for Rs,1125 then only we can consider it as “appreciation in Bond Price”. Please explain clearly.

Nitin Bhatia
Nitin Bhatia
8 years ago

Assuming face value of bond is Rs 1000 and coupon rate is 9%. In this case, 9% interest rate will be paid annually to the bond holder. If the bond is allowed to traded in the market, the value of the bond will increase or decrease depending on the interest rate movement. Assuming interest rate decrease to 7% then bond is yielding higher interest than market rate therefore bond will trade at premium and vice versa. At premium, you can sell the bond and take premium as you will forego higher interest rate for balance years compared to current market rate. If the interest rate increase then bond will not be in demand. Why i will buy a bond at less coupon rate compared to market rate therefore bond price will decrease. You will be at loss because you are getting lower interest rate then market rate. If you retain the bond till maturity then maturity value is same as face value of the bond. The issuer has already paid you interest for 10 years and at maturity the bond will cease to trade therefore there is No Premium and No discount.

Sanket Mohite
Sanket Mohite
7 years ago
Reply to  Nitin Bhatia

Perfectly explained !

Manish
Manish
8 years ago

Hi Nitin
Can you please suggest whether it is preferable to invest a lumpsum in ICICI Pru long term fund at this point in time. thanks

Nitin Bhatia
Nitin Bhatia
8 years ago
Reply to  Manish

The inflation is showing signs of upward trend and bond yield may move up therefore i will not suggest lump sum investment. You can also hedge risk by investing half the money in short term debt funds.

Mahesh
Mahesh
8 years ago

Nitin,

Very good article which can be understood by non finance people. Hope you will share more such articles.

Regards.

Sharmistha Deb
Sharmistha Deb
7 years ago

How to invest retired 20 lacs to get 12 percent steady return in present scenario.

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  Sharmistha Deb

In current scenario 12% returns looks impossible without risking capital.

Sharmistha Deb
Sharmistha Deb
7 years ago
Reply to  Nitin Bhatia

Then how to invest 20 lacs so that best return possible minimising capital risk looking 5yrs horizon, good equity tilted balance funds entering in staggered manner?

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  Sharmistha Deb

Though i am not a certified financial planner but personally i will invest in debt funds. The type of debt fund will depend on interest rate scenario. Expectation of 8% to 9% annual return is decent in current scenario.

Rsvramkumar Kumar
Rsvramkumar Kumar
7 years ago

Please be inform at the movement DEBT which investment will be good i will be invest lumsum only debt long duration, dynamic fund, income fund,long term fund can i prepare split to above the funds?

Nitin Bhatia
Nitin Bhatia
7 years ago

It depends on investment horizon and risk. The returns will depend on interest rate movement.

Rsvramkumar Kumar
Rsvramkumar Kumar
7 years ago
Reply to  Nitin Bhatia

please be sent details of Dynamic bond and income fund and long term fund which is good for long and high interest if risk means what? i take risk and long duration but i need high interest so which one is best for me? my mail id rsvramkumar@gmail.com

Nitin Bhatia
Nitin Bhatia
7 years ago

I request you to go through my post to understand the interest risk associated with the debt funds. Depending on your assessment of future interest rate movement, you may decide to invest in type of debt funds. As i am not a certified financial planner therefore cannot suggest any funds for investment. You may check websites that provide rating of mutual funds.

Ashok
Ashok
7 years ago

Isn’t Debt funds interest rates are somewhat directly proportional to Bank interests? As Bank interest rate is keep going down, does this affect returns from Debt funds?

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  Ashok

Debt funds provide returns don’t offer any interest rate. The returns depend on type of debt fund.

Pradeep Kumar
Pradeep Kumar
7 years ago

Dear Bhatia Ji
i have sold my house & invested my 25 Lac in Birla Dynamic 15 Nov & i loosimg a lot money what to do now?

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  Pradeep Kumar

Dynamic bond funds are not exactly long term debt funds as the fund manager keep changing the strategy in anticipation of future interest rate movement. If the calculation goes wrong then it can also deliver negative returns. You may keep a stop loss in mind and exit the fund if the stop loss is triggered i.e. NAV fall below the stop loss value.

supravat pramanik
supravat pramanik
7 years ago

can you suggest me to invest in oil and gas sector?

Nitin Bhatia
Nitin Bhatia
7 years ago

I am not bullish on oil and gas sector.

supravat pramanik
supravat pramanik
7 years ago

Suggest long term debt funds to an investor in the current economy??

Nitin Bhatia
Nitin Bhatia
7 years ago

As i am not a certified financial planner therefore cannot suggest any specific funds.

Sachin Khanna
Sachin Khanna
7 years ago

In the view of the recent RBI monetary policy hinting at no further interest rate cuts, is it advisable to stay invested in HDFC Corporate Debt Fund for 3 years time horizon

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  Sachin Khanna

The performance of this fund is average. In case of no further interest rate cuts, the funds with short term horizon will deliver better returns including HDFC Corporate Debt Fund.

manish k
manish k
7 years ago

Dear Sir,

I have invested 100000 in SBI Magnum Gilt fund – Long term plan in Jan 2017 based on pas returns. However, Currently the fund is showing negative returns. is it advisable to invest in gilt funds ( or in any debt fund) for long tenure of about 5 years or shall is switch to traditinal FDs.

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  manish k

As i shared long term funds perform when interest rates are on decline. Currently, it seems that interest rates have bottom out. In case, interest rates start increasing the long term debt funds will under perform. In my opinion, it is better to invest in dynamic bond funds. The fund manager will take a call whether to invest in long/short term debt funds depending upon the interest rate cycle.

manish k
manish k
7 years ago
Reply to  Nitin Bhatia

Thanks for your reply. i`m senior citizen. i want to invest 5 lacs in debt mutual funds which would give me returns more than FDs. My investment horizon is 5 years. i would be withdrawing returns generated in excess of my principal every quarter to meet day to day expenses. Please suggest me which type of mutual funds i should invest

Dynamic Bond
Debt short term
Debt income
Debt long term
Debt ultra short term

Nitin Bhatia
Nitin Bhatia
7 years ago
Reply to  manish k

I will prefer Dynamic Bond funds and Credit Opportunity funds.

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