Last month i sent information on debt funds because of rising yields. The appended write
up gives a basic understanding about working of debt fund and its importance in one’s portfolio.

What is Debt:
An amount of money borrowed and owed by one party to another. Government and
corporates borrow for working the firm and other requirements.
The debt market in India comprises of three segments. Government Securities Market, PSU
Bonds Market and Corporate Securities Market.

Government securities is the most prominent one in debt market and plays a very important
role in setting benchmarks in the financial markets.

Bond funds or debt funds invest in a mix of government and corporate bonds of varying
maturities. They derive returns from periodic interest payment from those bonds and  various
strategies.

Before reading further, I request to keep a thumb rule in mind,:

 The price of a bond and yield move in opposite direction.

For example when Interest Rates Rise Price of the existing bond Falls:

Let’s say a company X came to market to raise money with a coupon of 8%(interest). We call it
Bond A.
In the course of a year assume interest rates rises and the same company raises money at
8.5%.We call it Bond B.

Most common doubt one can get as an investor is why anybody would buy Bond A when
bond B offers higher interest rate.
Nobody would do that. So the bond A price needs to adjust downwards in order to match
with bond B interest.

Here how it works: Bond A is priced at Rs 1000/- and it pays an interest of 8%. It pays Rs 80
annually. But Bond B offers 8.5% interest. So in order to remain competitive the price of Bond

Aneeds to fall. It need to be sold for apprx Rs 940 instead of Rs 1000/-, so that it matches the
interest of 8.5% offered by Bond B. (80/940*100=8.50%) (coupon/price*100)

The same is the case with Rates fall Price Rise. The opposite of the above example works. I.e,
The price of a bond moves up. Assume the same company issues issued bond with interest of
8%. But this time the interest rates fall by 0.5%. The same company now issues a new bond
with 7.5%.

So what happens to the first issue? The price of the first bond needs to adjust upwards in line
with the new issue. It needs to be sold for Rs 1065 in order to match the current interest rate of
7.5%.

The above-mentioned example will not happen in same manner in real as there are other
various determining factors. The idea is to give a basics of its functioning. There are various
moving parts which determine the interest rates in the economy.

To Sum UP: Bonds that have already been issued and that continue to trade in secondary
market must continually readjust their prices, and yields needs to stay in line with current
interest rates.

By investing in debt or bond funds the respective funds take care of all this. As an investor
there is a difference of apprx 2% return compared to FD, because of tax treatment and varied
rating instruments and they are the effective source to generate cash flows in a tax efficient
manner,particularly for Sr. Citizens.

Important point to take note is a person who bought a bond and holds it till maturity will
receive the promised rate irrespective of market rates. Example is Tax Free Bonds (many of
you subscribed to it)