Interest Rates Debt
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Debt funds are safer and less volatile when compared to other asset classes. Debt funds can be an important component in asset diversification. Given the global economic conditions, many analysts believe that debt funds can play a major role in balancing portfolios.[br]
Table of Contents
Interest Rates Debt – Low Interest Rates
Debt funds and interest rates are inversely related. When interest rates decline, the net asset values of debt funds increase, and vice versa. Central banks across the world have been reducing interest rates to stimulate economic activity and improve liquidity. Essentially, lower interest rates make borrowing costs cheaper and facilitate increased production activities and low-cost borrowing. As of end-2009, the benchmark interest rates of most countries have been at very low levels.
Interest Rates Debt – Reduction in Spread
Debt funds usually invest in corporate bonds and government securities. The proportion and the type of instruments in which a debt fund is invested decide its NAV (Net Asset Value). The NAV of the debt fund appreciates when the interest rates fall. The rates of government securities across the world are less than corporate bonds. The difference in the interest rates of these two instruments, called spread, has been widening. As the interest rates decline, the interest rates of corporate bonds will go down. When the spreads reduce, bond funds will benefit more as compared to government securities.
Interest Rates Debt – Asset Allocation
Given a low interest rate and reduction in spread, it is better to invest in long-term bond funds and long term gilt funds. Gilt funds invest only in government securities while bond funds invest across debt asset classes such as corporate bonds, government securities and CDs (Certificates of Deposit). Although government securities are safer than corporate bonds, the former can become more volatile due to higher liquidity.[br]
Given the market conditions across the globe following the 1998 financial crisis, corporate bonds are expected to outperform government bonds in the long term. It is good to invest equal amount of money in both gilt funds and bond funds to reduce risks. The investment horizon should be more than one year. It is better to avoid debt funds if one cannot hold the investments at least for a year.
