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The Relationship Between Bonds And Interest Rates

For experienced investors, changes in interest rates present an interesting opportunity to earn extra returns. For the rest, accrual funds are a good choice

The interest paid on debt fund holdings is not their only source of income. Most of the bonds that these funds invest in are also traded in the debt market, just like equity shares are traded on a stock exchange. Like anything traded on a market, the price of each bond can rise or fall resulting in capital gain or loss. When the price of a bond rises, it results in additional gains for investors of the mutual fund which invests in these bonds. The opposite is also true, when the price of a bond falls. However, this may not necessarily result in a loss to investors as they would still be entitled to the interest or coupon component. A loss would only be incurred if the fall in the bond price is more than the coupon payment from the bond.

But why should the prices of bonds rise or fall? After all, the only source of income that flows into a bond is the interest paid on it, and this interest is fixed. Here’s what actually happens. These price changes generally happen in response to a change in interest rates, or even the expectation of such a change. Suppose there is a bond that pays out interest at a rate of 9% a year. Subsequently, the interest rates in the economy fall and newer bonds start getting issued at 8%. Obviously, the old bond should now be worth more than earlier. After all, a given amount of money invested in it can earn more interest. Hence its price would now rise. Mutual funds that hold it could make additional profits by selling this bond. Obviously, the reverse could also happen when interest rates rise and such a situation could actually result in some losses for a bond fund. Hence bond yields (interest rates) and its prices move in opposite directions. This is also called as interest rate risk. It is thus a myth that debt mutual funds may always give positive returns.

Using Debt Funds To Profit From Interest RatesThere is also another angle to the rise or fall in bond prices. It is also proportionate to what is called the residual maturity of a debt fund meaning number of years left for the bonds to be redeemed or to mature. How does this work? Take the same example as above. Suppose there is a bond that pays out interest at a rate of 9% a year. Subsequently, the interest rates in the economy fall and newer bonds start getting issued at 8%. When interest rates fall, bond prices would rise. Further assume that there are two such bonds, one has a one year residual maturity while the second has 5-years of residual maturity. Obviously the one with the longer residual maturity (5 years) would have a greater demand than the one with 1 year of residual maturity. This is because the bond with the longer residual maturity (5 years) would benefit fromits higher coupon for a longer period of time.

What happens if interest rates rise? Obviously the cost to the issuers of bonds would increase as they need to pay higher interest or coupon. Hence they would prefer to issue shorter tenure bonds so that this higher cost is restricted to a shorter period. Hence in such periods there is more supply of short term paper. Mutual funds buy this paper in their short tenure funds and benefit from higher accruals. Hence in a rising interest rate scenario mutual funds make higher returns from accruals (or coupon payments) and in a falling interest rate scenario they make higher returns from capital gains. Thus, shorter maturity bonds are in demand when interest rates are expected to rise and longer maturity bonds are in demand when interest rates are expected to fall.

However, this is easier said than done. To profit from change in interest rates one needs to have a view on interest rates and learn to switch between high maturity and low maturity bond funds when the interest rate cycle is expected to change. Further, one may face losses if the call goes wrong. Is there a middle path? Yes,one may invest in a category of bond funds called accrual funds which try to profit from high yielding short to medium maturity bonds. Most of the returns from such bonds come from the interest component and very less from the capital gains component.


Returns from bond funds comprise of interest income and capital gains / losses due to change in underlying bond prices. The latter is inversely proportional to expectation of interest rates. Bond prices rise when interest rates fall and vice versa. Further, long maturity bonds benefit when interest rates fall as the capital gains (rise in bond prices) component contributes to majority of the returns. Short maturity bonds benefit when interest rates rise as bond prices fall and this fall is less for short maturity bonds than long maturity bonds. It is, however, very difficult to anticipate the direction of interest rates and accordingly invest in long or short maturity bond funds. Instead a middle path is to invest in accrual funds wherein majority of the returns come from high interest yielding bonds while price change is a very small component owing to the short to medium bond maturity.

Next To Come: Importance Of Asset Allocation