Although past performance is no guarantee for future returns, it does give an indication of how a fund has performed in rising, falling and volatile markets. It’s one of the several indications we look at before investing. But while for equity funds you can look at past performance for some indication, in debt funds it doesn’t make sense to look at past returns.
When interest rates rise, prices of debt securities fall. In simple words, assume a debt security issued today pays you 10% interest. Two months later, assume that interest rates rise and new debt papers hit the market giving you an interest rate of, say, 11%. Naturally, the value of the first debt paper loses its value since it pays less interest than the new debt papers. So its market price falls. This is called the inverse relationship between the interest rates and market prices.
…Determine the debt fund’s performance
In a rising interest rate scenario, long-term bond funds suffer the most. Since these funds hold securities that, on an average, mature after three years or more, the value of their underlying securities would continue to fall as interest rates rise. In the past one year as interest rates were inching up and mostly volatile, long-term debt funds managed only about 6.81% returns on an average. Even liquid funds managed better and returned 7.86% on an average last year. So when is the past performance a good indication and when it isn’t?
Doesn’t fund management matter at all?
Typically, avoid paying too much attention to immediate past performances of those debt funds that warrant long-term investments. The reason: since you need to stay invested for the long-term, you need a favourable interest rate scenario to prevail over a long period of time. Since interest rates were on a consistent rise (the Reserve Bank of India has raised its key lending rate 13 times since March 2010 to fight inflation), long-term bond funds haven’t done as well in the past year.
However, that doesn’t mean that they should be ignored going forward. Many debt market experts feel that we’re at the last leg of the interest rate hikes and that interest rates would start falling from the first quarter of 2012. When interest rates do start falling, medium- to long-term debt funds are bound to do well. Their performance then will be a stark contrast than their performance at present.