Friday, October 26, 2007

What is a Debt Fund?

n the world of investments, the higher the risk you take, the higher the returns you can get.

Since there's a known cash flow associated with debt, the risk is less. But the returns are also less.

When compared with equity funds, the risk for the latter may be more. This is because there's a steady cash flow associated with debt paper. In fact, the interest which the debt paper promises to pay (known as 'coupon' in financial parlance) is one of the fundamental attributes of a debt paper.

However, debt paper shares a very fundamental relationship with interest rates. To understand this relationship and how that can be used in present day context to make money, you must understand the basics of debt.

What is a Debt Fund?

It invests predominantly in debt paper, which is issued by the person who takes the debt (borrower) to the person who lends the money (lender).

The paper quotes how much money has been taken, for how many years the money has been taken and what will be the interest paid on this money every year.

So, the person who has lent the money knows how much interest he will get every year. Furthermore, at the end of the tenure of the loan, he will also be repaid the principal. So, in case of a debt fund, it invests in different debt papers. Each paper will have a unique maturity and a promised interest rate.

How Debt Funds Relate to Interest Rates
 
Debt paper prices share an inverse relationship with interest rates. As rates rise, prices of debt paper fall and vice versa. As rates moved south from 2001-02 to 2003-04, the investor will remember that the price of debt papers moved north in the same period.

Then, as rates started climbing thereon till 2005-06, bond prices fell. Investors, also make a note that reaction in prices of bonds with higher maturities is more pronounced.

Present Scenario

Interest rates are nearing the peak but the same logic will be applicable, and this time, bonds with higher tenures will stand to benefit the most. The question is not whether this will happen, but when will it happen?

Markets don't wait for things to happen, they discount the future. Sometime, sooner rather than later, smart money will start flowing into debt funds, particularly those whose portfolios have high maturities.

Keep a tab on inflation every week. Tracking debt fund AUMs will also help. Inflation cooling will be the first signal; indicating interest rates could be headed south. When the process will begin, how much will rates come down, is under speculation. It’s a risk, but then it involves returns as well.

Quick Tips

Even if you were to look at the maturity and coupons of debt funds, and were to profit from it, lack of proper financial planning can result in not building on the gains made. Investing in an ad-hoc manner does not have the potential to multiply your gains.

Hence it is always suggested, to first have a detailed financial plan, and then make asset allocation (strategic/ tactical), based upon your risk profile, available opportunities, etc.

Draw a proper financial plan, based upon your future goals/ requirements and then build a portfolio across assets to have proper diversification and potential to make returns.

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