Floating rate bond funds

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Allyson Atkins
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3 With markets on the road to recovery, equity linked funds often enjoy the status of a preferred investment avenue by most investors. In such a situation, the potential that long term gilt and bond funds hold is often ignored. Let s find out how these bond funds work and when one could invest in such funds! Gilt and bond funds are mutual funds which seek stable returns, as they are exposed to lower risk than equity funds. Investors funds are invested in an array of fixed-income securities such as bonds, debentures, money market instruments and government securities (g-secs). Thus bond funds provide an opportunity to retail investors to invest in the bond markets, which otherwise is open only for HNIs and institutions as the minimum investment size in these markets is very high. How do these funds work? The NAV of the fund rises with the rise in the prices of the underlying assets (bonds and g-secs). The price of these underlying bonds and gilts are primarily impacted by interest rates; supply of bonds and g-secs in the market and the maturity profiles of the securities. Interest rate is the most important factor that drives the prices of bonds and g-secs. Buyers look for low price and high yields (yield is nothing but the return on investment).there is an inverse relation between the price of a bond and its interest rate, i.e. bond prices fall when interest rates rise and vice versa. When there is a rise in the interest rates, most of the newly issued bond funds offer higher yields in order to maintain pace. As a result, the existing bonds that trade at comparatively lower coupon rates (the rate at which an investor gets interest on the investment) become less sought after. Investors buy these existing bonds only at a reduced price in-order to seek optimum returns as per prevailing interest rates. On the other hand, when there is a fall in the interest rates, the existing coupon rate of the bond becomes competitive, thus leading to a rise in prices. This can be explained with the help of an example Let s say that you have invested Rs 50,000 in a bond with 5 per cent coupon rate. If the overall interest rate rises to 7 per cent due to market dynamics, the demand for the 5% bonds will fall. Investors will buy these bonds only if the price is reduced and the yield on the bonds is close to 7 per cent. Similarly, if the interest rate decreases, the 5 per cent bonds can be sold at a higher price as demand for these bonds will rise. The maturity profile of bonds also affects the market price of bonds. If the maturity of the bonds is very short - say 14 days, then even a huge rise in the interest rate will have a negligible effect on the market price, as the investor will not sell the bonds at a large discount since he can take advantage of the increased rate of interest after the maturity of the bond. On the other hand if an investor has a bond with a longer maturity and the interest rates rise, the buyer of such a bond will ask for a significant discount as he will be forgoing the opportunity to earn higher interest for a longer period of time. Thus bonds with shorter maturity are less risky than those with longer maturity as the volatility in the former is low. However, this also means that the potential returns from short term bonds are lower than those from long term bonds. The graph explains the relation between the maturity period and market price of the bonds. As the maturity date approaches the discount or the premium narrows down. Like any other market, the bond market is also affected by the demand and supply factor. The higher the supply of bonds and g-secs, the slower is the appreciation of prices and vice versa. Current Interest Rate Scenario In order to boost demand, the RBI had reduced interest rates in the economy amidst the financial crisis. However, in the wake of high inflationary trends, the government has begun raising the interest rates. As one of the steps towards this, after a long time, RBI has recently raised the Cash Reserve Ratio (CRR) by 50 basis points; and the repo and the reverse repo rate by 25 basis points. This increase in the interest rates may affect the NAVs of bond funds in a negative way because of the phenomenon explained above. When this happens, it may be a good time to get into such funds to take advantage of appreciation in the long run. Floating rate bond funds

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