Debt investment is the most popular form of investment in India. Most of the debt investments are in the form of bank deposits, bonds, company deposits etc. But when we think about mutual funds we only think of "equity". Debt mutual funds have not gained much popularity at the retail level. So let us take the patch that leads us to discover the elements and dynamics of debt mutual funds.
| 1) | A debt fund is an aggregation of different debt instruments. A debt fund manager |
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| a) | Gets inflows from investors |
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| b) | Buys debt securities usually of varying maturities as per the Fund's investment objective. (If the fund is an FMP the debt papers will be of maturities matching the maturity of the fund.) |
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| c) | Makes sure the interest income that the debt securities generate is invested. |
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| d) | Ensures that he is in a position to pay investors who wish to redeem. |
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| 2) | The returns of a debt fund are a combination of |
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| a) | Return from interest earned (called accrual) |
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| b) | Change in the market value of securities (called mark-to-market or MTM). Here it is important to note that when interest rates are expected to drop, the price of the debt securities rise and vice versa. |
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| To understand the concept of combined income think of the hair dresser who earns a fixed salary on one hand but also earns tips from customers on the other hand. If the hair dressers' luck is good and his customers like him, he can make a lot of money through generous tips. Similarly, a debt fund earns an interest income like a salary and can stand to gain in terms of capital gains which are like the extra income of the hair dresser. Just as the extra income is not stable, the capital gains too are not certain. However there exists one difference between the hair dresser and the debt fund. While the hair dresser does not stand a chance to lose money and in the worst case scenario may have zero extra income if nobody tips the hair dresser, the debt fund on the other hand could experience capital losses if the prices of debt securities the fund holds falls.
The capital gains / losses that can affect a debt fund are a function of the fund manager's ability to judge the future direction of interest rates by analyzing the overall macro-economic environment. The fund manager's skill thus lies in estimating the interest rate outlook well in advance and altering his portfolio accordingly so that his investors stand to gain from the same. |
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| 3) | There are some debt funds like "Liquid" funds where the returns are attributed mainly to interest accrual whereas there are other debt funds like "Income" funds where the returns are attributed mainly due to the change in the market value of securities. However returns of most debt funds are a combination of these two factors in varying proportions. In funds like Liquid funds where the returns are primarily due to interest accrual, the growth of NAV (Net Asset Value) is seen to be very steady. But in funds such as Income Funds where the proportion of the MTM component is large, the NAV shows a volatile journey. Wherever the fund manager's call is right, the NAV gets a boost. Otherwise it can unexpectedly fall. However since the component of interest accrual is steady in character over the long term, the debt fund's NAV continues to move upwards. |
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| 4) | Your choice of fund should be a function of your investment horizon and risk appetite. If your investment horizon is short then you should invest in a safe Liquid Fund where the return is primarily due to interest income. As such, over a short time horizon there does not exist much of an opportunity for MTM gains. Hence for short term investments it does not make sense to invest in a debt fund which has even a small element of risk.
However if your investment horizon is long and if you have a reasonable appetite for risk, you could look at investing in an Income / Gilt Fund having securities of longer durations. These funds stand to gain from the MTM component if the fund manager's outlook on interest rate turns out to be accurate. |
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| 5) | During times of high interest rates when expectations of rate cuts by RBI is high, one should seriously consider long duration debt funds like Income and Gilt funds as they are well poised for both MTM and high interest accruals. |
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| 6) | Expenses directly impact the return of debt funds. If a fund earns 10% as interest income and pays 2% as expense, 20% of its direct income is gone. Between two debt funds with similar average maturity, NAV volatility, and return, simply select the one with a lower expense ratio. |
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