We all know that interest rates are set to move up, rate cycle reversal is a matter of time. Since interest rates and bond prices move inversely, as long as interest rates are moving up, returns from bond funds will not be good. There is another popular practice, of looking at the portfolio YTM (yield to maturity, the accrual level of the bonds in the portfolio) and taking it as a proxy for the expected return from a debt fund. Now let us put all these together.
When interest rates move up in 2022, the portfolio YTM of debt funds will move up. So when will the benefit of higher yields (interest rates) in the market flow to investors? Herein comes the relevance of debt fund portfolio reset.
The coupon rate of a bond is a constant and is not contingent upon interest rate movements in the market. If the face value and issue price of a bond is say Rs 100 and the coupon rate (interest rate) is 5%, interest pay-out is Rs 5, no conditions attached. Also, let’s say the weighted average YTM of all the bonds in the portfolio of a debt fund is 5 per cent. Thereafter, interest rates in the market move up and the YTM for daily valuation of NAV moves up to say 6 per cent. The relevance of this is, that the price of the bonds for daily NAV computation, will be taken as that corresponding to 6%, which will be a lower than the face value, since yield and price move inversely. But, as the coupon accrual in the fund portfolio is happening at 5% and not 6%, how does one reconcile that?
Portfolio maturity matters
Over a period of time, as and when the instruments in the portfolio mature, the face value comes back, and the portfolio gets the benefit. How? Let us say for the bond with a face value of Rs 100 that was being valued at Rs 99 due to yields moving up, on maturity, the portfolio gets the benefit of Re 1, to the extent of holding in the portfolio.
Hence the whole question is, what is the length of the cycle for the entire portfolio of bonds or other instruments to mature? The indication for that is the portfolio maturity of the fund, which is the weighted average of all the instruments in the portfolio, which we can refer to in the fund factsheet. Though, technically the portfolio maturity is subject to change due to maturities and purchase of fresh instruments, we get the indication. In a Liquid Fund, if the portfolio maturity is say 1 month, in a month or so, the portfolio gets reset. In a longer maturity fund, it takes that much longer, while the adverse impact of yields moving up is higher.
When interest rates move up, shorter maturity funds like Liquid, Ultra Short, Low Duration etc. will gradually get the benefit in 2022. Not to give high hopes; interest rates are on the lower side now, but gradually the accrual level of debt funds will normalize i.e. move from very low levels to reasonable levels. So, if your investment horizon is not very long, go for shorter portfolio maturity funds as the interest rate reset happens faster here.
The writer is a corporate trainer and author