Understanding debt funds. My article in Mid-day Mumbai edition of 8th June, 2015
The English translation is as under:
The English translation is as under:
When we talk to investors about mutual funds, they assume the discussion to be about equity mutual funds. Somehow, mutual funds have been very strongly associated with equity.
What is the reality? Well, the reality is that a mutual fund is just a vehicle that invests in various securities. These can be equity or debt.
Fixed income mutual funds, popularly known as income funds or debt funds, invest in debt securities issued by either the Government or companies, including banks. These debt securities are also known as debentures or bonds if the term is longer than one year, and treasury bills, commercial papers or certificates of deposit if the term is less than one year. The debt securities are obligations on part of the issuer to pay the principal and interest thereon as per an agreed time schedule.
This concept of debt investments is familiar to most investors. Majority of the Indians have invested in these investment options, either through bank deposits, or small saving schemes, etc. All the fixed deposits or other such fixed income investments have a face value on which interest is calculated. Investors are mostly concerned with face value, interest rate, frequency of interest payment, the time period, safety of the investment option and maturity value. Most often these investments are held till maturity.
As compared to that, debt mutual funds are not investments by themselves, but a vehicle that invests in the debt instruments.
These debt instruments pay periodic interest and there can be some trading gains generated by actively buying and selling the debt instruments by the portfolio manager. Both the interest and trading gains form the income for the debt funds.
These gains (or losses) are reflected in the NAV, which incorporates daily changes in prices or interest income. Thus, if a bond has to receive interest of Rs. 365 in a year, the daily component of interest, i.e. Rs. 1 would be added in daily NAV. At the same time, the price of the bond may go up or down in the secondary market, which will also be factored in the NAV calculation.
Most of us are unfamiliar with the changes in market prices of bonds, since almost all of our debt investments are held till the maturity date. Hence, let us spend some time on understanding why the prices of debt securities change.
First of all, as we know all debt securities carry interest rate payable to the investors. While the interest rate on a particular debenture remains constant from issue till maturity, those in the economy may undergo a change during the same period. Thus, if the interest rates in the economy increase, all the existing debentures become less attractive and hence see a drop in the prices. On the other hand, if the interest rates in the economy go down, the prices of existing bonds go up. This is known as interest rate sensitivity. This is the major reason why the prices of bonds move up and down in the market. This has an impact on the NAVs of debt funds.
Debentures with long maturity are more sensitive to interest rate changes compared to those with short maturities. This is understandable since the debentures with longer maturity will pay the original rate for a longer period, whereas those with short maturity would mature early and the investors would get a chance to invest at the new rate.
The interest rate payable by a bond also depends on the creditworthiness of the debenture issuer. If the issuer is considered to be of high quality, one may accept a low rate. If the issuer’s creditworthiness is not so good, the investors would not invest for low returns and the issuer may have to issue the debentures at high rates.
Any change in the perception of the creditworthiness would result into a change in the bond’s price. If the market perceives improvement in creditworthiness, the bond’s price would go up and vice versa.
All these changes would make the NAV go up or down. It is important to understand this before investing in fixed income funds.
You may check some information from the fact sheet in order to understand the above points: (1) average maturity of the portfolio, and (2) credit profile of the portfolio.
The former indicates the sensitivity to interest rate changes while the latter indicates the credit risk taken by the fund.
Debt funds are good investment vehicles. Use them to your advantage.
The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.
Disclaimer: This article should not be construed as investment advice.