Long term income funds are a category of fixed income funds that aims to generate returns from investments in longer maturity government and corporate bonds. The principle behind long term income funds is that long maturity bonds have a higher correlation to interest rates than short maturity bonds i.e. the prices of long maturity bonds rise more than the prices of short maturity bonds when interest rates fall . Long term funds generate returns through both interest and capital gains.
Let us take an example of a typical long term income fund portfolio.
The portfolio in Table 1 will yield 8.95% every year if interest rates remain unchanged. The investor will receive the portfolio yield less expenses of around 1.5% to 2%.
Changes in interest rates will take up or take down the return from the portfolio. Taking an example of a fall/rise in interest rates by 1% or 100bps and assuming that the credit spreads remain unchanged the portfolio returns will be as follows.
Total return of the portfolio is the capital gains/loss plus portfolio yield. Investors will get 15.05% less expenses if interest rates fall by 1% while they will get 3.05% less expenses if interest rates rise by 1%. We are taking this portfolio as a bond paying annual coupon of 8.95% and having a maturity of 10 years
Changes in credit spreads affect the portfolio returns
Portfolio returns are subject to change in credit spreads. If credit spreads go up then portfolio returns will fall while if credits go down portfolio returns will rise. Taking an example of credit spreads falling or rising by 0.5% while interest rates go down by 1%, the returns will be as follows. In Table 1. we that the portfolio has 50% weight in government bonds and 50% weight in corporate bonds.
A fall in interest rates by 100bps will bring down government bond yields to 7.5% but a rise in credit spreads by 50bps will bring down corporate bond yields by 50bps to 8.9%. Hence the overall portfolio gain would be lower than that of the gain seen in Table 2. Table 3 gives the differential gains due to fall in government bond yields and rise in credit spreads.
Investors in long term income funds are exposed to a) interest rate risk and b) credit risk. Hence investors should have a level of understanding of yields on government and corporate bonds and of credit spreads, which is the difference between the yield on the government and corporate bond of similar maturity.
