Here’s the Role of Yield Curve in choosing Debt Funds:
Yield Curve is a line graph that demonstrates the relationship between yields and maturities. Yields are expressed in percentage and maturity is depicted in years.
It can be used to compare the yields of bonds of same credit risks but different maturities. The yield curve is created when yields of different maturities are plotted.
The yield curve is significant in matters of fixed income investing. Bonds, debentures, commercial papers, G-Secs, treasury bills, etc. fall under this. Debt mutual funds too, relate to this domain. Additionally, it gives an insight into the future outlook of the economy.
A bond relates to a loan provided by subscriber (you) to the issuer (company). Bonds have different yields based on credit risk and maturity.
It can be understood with a simple illustration.
Suppose you give loan of Rs 2 Lakh each to A and B. A’s loan will mature in 1 year while B’s after 7 years. Here, the probability of getting back the loan is higher for A than B. It’s because A got it for a shorter term than B. So, A will have to pay interest at a lower rate than B.
A similar phenomenon is replicated in case of bonds and debentures.
Fundamentally, AAA-rated corporate bonds are perceived riskier than G-Secs. So, the former has a higher yield than the latter. Similarly, longer maturity bonds are riskier than shorter maturity bonds. Accordingly, former has a higher yield than the latter.
Types of Yield Curves
The difference between yields on securities of different credit risks is called Spread. This spread determines the shape of the yield curve. It can be upward-sloping, downward-sloping or flatter depending on the economic outlook.
Yield curves are influenced by factors like monetary policy, investor expectations, inflation/recession, etc. The short-term interest rates are regulated by RBI; long-term interest rates are monitored by market forces of demand and supply.
1. Normal Yield Curve
It is an upward-sloping curve. In this, short-term yields are lower than long-term yields. The shape follows the risk-return principle. The risk in holding long-term bond is higher than shorter-maturity bonds. It’s because longer maturity bonds are more vulnerable to interest rate fluctuations. Hence, you will get relatively higher yield in long-term investing.
It’s also an indicator of future economic expansion and inflation. Inflation will cause a rise in policy rates which will reduce the future bond prices. As bond prices fall, the long-term yields will rise.
However, a high demand for shorter-maturity bonds increases their price. It results in a fall in the yields.
2. Inverted Yield Curve
It is a downward-sloping curve. In this, short-term yields are higher than long-term yields. The shape follows inverse of the usual risk-return principle. It happens because of a recessionary future economic outlook.
The recession will cause the interest rates to fall. It will increase the prices of longer-maturity bonds. It, in turn, causes the bond yields to fall.
Another reason for the downward-sloping curve is investors’ perception. They regard longer-maturity bonds as more valuable leading to an increase in their demand. Consequently, the prices of shorter-maturity bonds fall and their yields rise.
3. Flatter Yield Curve
Sometimes you may find an insignificant difference in short-term and long-term yields. These might seem equivalent to each other. In such a scenario, the investor may not receive any risk premium for holding bonds for longer maturity.
The yield curve, thus, becomes parallel to the x-axis. It becomes flattered indicating a declining spread between bonds of different maturity. The investors may be unsure about the future economic outlook.
Yield curves flatten even when the economy is recovering from a recession. In this case, fall in long-term interest rates is more than the rise in short-term rates.
Also read: Best GILT funds for 2017
Implications of Yield Curve on Debt Fund Investing
Understanding of yield curves is crucial towards wealth accumulation via debt mutual funds. The yield curve is suitable whether you have a short-term/long-term investment horizon. Based on your investment horizon, you analyse that particular portion of the yield curve.
In the case of open-ended debt funds, returns are determined by the level of the NAV. Yield curve helps to assess the worth of specific debt fund. It will guide you about bond prices and resultant NAV at particular maturity. It will also exemplify the interest rate sensitivity of fund returns.
Rising yield curve means lower prices of underlying bonds of debt funds. Lower bond prices indicate substantial loss of fund NAV. There’s no use of investing in GILT funds/corporate bond funds of smaller worth. Conversely, liquid funds and income fund NAVs would be rising. It’s better to go for short-term debt funds in such cases.
Inverted yield curve means higher prices of underlying bonds of debt funds. Higher bond prices indicate a rise in the fund NAV. GILT funds/corporate bond funds would become ideal investing opportunities. Conversely, liquid funds and income fund NAVs would be falling. These would be worth avoiding due to a lower value.
In yet another case, inverted yield curve can be used to cash in on close-ended funds; especially fixed maturity plans (FMPs). Here, your concern should be on bond yield rather than bond prices. Owing to a shorter tenure of 2-3 years, FMPs would absorb the goodness of high short-term yield. At the same time, it will mature to escape the adversity of falling long-term yields.
Sometimes, the curve may neither rise nor fall. Instead, it might be staying flattered at certain yield. It is an indication of uncertainty regarding the future course of interest rates and bond yields. You might be unable to predict whether the interest rates would rise/fall in future.
But fret not! You can still put yourself in an advantageous position. Invest in Dynamic Bond Funds. These funds operate on flexible maturity, unlike GILT Funds. The fund manager would keep adjusting the fund’s maturity to benefit from interest rate fluctuations.
So, whether the interest rates rise or fall, you would be assured of desirable returns.
Debt funds can be an ideal wealth accumulation tool. The only thing required is to know the rules of the game. The yield curve can become your loyal friend in sailing through debt fund analysis.