Relation between Debt fund NAV and Change in interest rates

POSTED BY vikram.iitk ON June 8, 2012 11:24 am COMMENTS (7)

I have one query regarding mutual funds…bond funds.
The underlying asset of any bond mutual funds are bonds of a company
or of government of various maturities and it is also true that as
interest rates ( or yield) increases the value of bond falls.
When the value of bonds falls, the asset of the bond mutual funds and
corresponding NAV of the mutual fund should also fall..( which holds
that bonds in their portfolio). Is it true?
Now, as we know that RBI has increased interest rates last year a
number of times ..this means last year the prices of bonds should fall
and NAV of bond funds should also fall. But, as I see from the
historical data of all the bond funds..their NAV is increasing
continously for last 5 years.? Why it is so? Why the NAV is not
falling during the time when RBI was increasing interest rates?
Kindly answer this query as this will help me to take a decision
towards investing in bond mutual funds. ( I am thinking that as the
interest rates are towards downward trend…this should increase the
value of underlying assets of debt fund and should appreciate NAV of
these fund and shall I expect better than average debt fund return of

7 replies on this article “Relation between Debt fund NAV and Change in interest rates”

  1. says:

    Thanks Anshal…i was under the impression that coupon rate will change with prevailing interest rates. going forward what will you recommend ..a SIP investment in a bond fund or a lump sum investment for two years horizon…say Rs 2000 per month for 2 years or Rs 50,000 lump sum and wait for 2 years?

    Also I saw some where in your posts that you recommend Birla sun life bond….shall i go ahead with it?
    Thanks again,

    1. Dear Vikram, it’s your personal call to invest 50K in lump sum or to scatter the amount. I can’t decide it for you. Recommendations are based upon the individual discussions. Some one’s food may be poison for other.

      By the way it’s Birla Dynamic Bond, you are referring to.



      1. says:

        Thanks Ashal for your response and for discussing this issue.
        Thanks to all.

  2. says:

    Thanks Banyan and Ashal for your response. So, two cases

    a) When interest rate rises:- The increase in coupon rate and decreasing bond prices work in opposite direction.

    b) When interest rates fall :- The decrease in coupon rate and increasing bond prices work in opposite direction.

    The resultant effect of these two forces determines the over all return on investment in any bond fund ( how ever small it may be, 99.9 percent of time it will always be positive)

    Now, I considered these two approximate cases for past Indian market scenario:

    1) 01-may-2008 to 31-dec-2009 ( 1.5 years) when interest rates were DECREASING.
    2) 01-Jan-2010 to 01-Jan-2012 ( 2 years) when interest rates were INCREASING.

    and I tried to calculate ‘absolute annualized returns’ and ‘SIP annualized returns’ for various best rated bond funds for these two cases. ( calculator from and for some of the funds data was not available for 1st case…as these funds were new). I considered following funds ( all growth plans):

    1) SBI Dynamic Bond fund
    2) Kotak Gilt Investment Plan
    3) UTI bond fund
    4) Principal Income fund long term plan
    5) Morgan Stanly Short term bond fund
    6) J P morgan India short term Income
    7) Birla Sun Life Dynamic Bond Fund
    8) Religare Credit opportunities Fund.

    Across the funds, I found that the difference in returns in two scenarios was in the range of 0.5-1 percentage points and also in none of the above cases the annualized interest rated were above 9%. ( approx FD rates) and to the contrary…..the returns in case of SBI and UTI funds were higher in the case when interest rates were rising !!!!!!!! What is happening here??

    Now, since we all know that the interest rates have peaked and it is time that they will go down in a phased manner and will become constant for some time..( say in next 2 years).

    My question and doubts are : a) Is the return on any bond funds depends on its category? like ultra short term…short term….long term… gilt fund? and if yes, then which category will give maximum return in present case scenario..( 3 years from now and decreasing interest rates).

    b) Any particular specific bond fund which you recommend for 3 years horizon period?

    c) And most important….say I am ready for forgo 0.5-1% extra return ( if any) on bond funds, shall I go ahead with FD in bank what extra advantages bond funds have over FD?

    d) and since I KNOW that the interest rates will fall from here….shall I put a lump sum amount in good bond fund for 3 years or go for SIP mode? I mean … I have an advantage of having this knowledge of interest rate trend over an ignorant investor?
    ( surprisingly from my data SIP returns were higher even in the scenario of falling interest rates …..why this is so?….in equity if i know the trend…i can take advantage of lump sum investment over SIP… same principal applies in bond fund?


    1. Dear Vikram, first of all please correct your understanding. The coupon rate normally remains same if not specified for a variable one. So at the very start of your reply/query the point b is not what you are understanding. The coupon rate is same but it’s the price of the bond which is increasing & thus there is more positive impact on NAV of the fund holding that bond.

      One more thing – You are thinking that fund manger is keeping the same portfolio al the time. No my dear friend it’s not like that. Depending upon the interest rate situation, fund manager ‘ll make a call on the bonds to be in the portfolio. This change in bond holdings ‘ll also impact the performance up or down both way.



  3. Dear Vikram, please read my reply in addition to what dear BanyanFA has already discussed. For past 5Y the bond funds NAV were increasing always. Why? When the price of bonds are not moving, the coupon rate of that bond is providing a fix return specially in the increasing rate scenario although in this case the increase in NAV ‘ll be lower due to drop in bond price.

    On the other hand, when interest rates in the economy are on decline, the bond price ‘ll increase the NAV sharply.



  4. BanyanFA says:

    You have an interesting query. Bond funds hold bonds as their underlying assets. Bonds with long term maturity provide two types of returns :
    a) Coupon payments / accrual – The interest being accrued adds to the value of the bonds;
    b) Capital Gain – this is where the interest rates prevailing in the economy either pushes the prices of bonds or pulls them down (if interest rates go up).

    Hence, even though the interest rates are going up, bond prices will try to go down and hence try to offset the interest accrued there on. However, the downtrend in the prices will not push the prices to negative.

    The effect is more steeper and evident when the interest rates are high enough. One RBI starts reducing the rates, the bond prices shoot up. This complements the coupon accruals as well.

    Does it answer your query ?

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