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How Debt Mutual Funds Earn Returns

All categories of Debt Funds are not ideal at all points of time. To avoid heartache later, make sure you consult with a professional, competent Financial Advisor before you invest.


Shrikant Rajput (name changed) took the plunge from Fixed Deposits to Mutual Funds a year back. After doing a little bit of research, Rajput zeroed in on the direct plan of a dynamic bond fund from a leading asset management company. Before investing, he noted that the fund’s “yield to maturity” stood at nearly 8% - and so he invested with confidence, assuming that he’d get a minimum return of 8% from his investment – a whole lot better than prevailing FD rates. A year later, Rajput’s investment is down 1.01%, and he’s disillusioned about Mutual Funds as an investment avenue.

Rajput’s story is a common one – as debt funds haven’t exactly rewarded investors richly in the past year. But more than his poor returns, his consternation stems from a poor understanding of how debt fund returns are actually earned. Rajput’s fallacious belief that a debt fund will at least earn as much as the interest income that its portfolio bonds would generate, is in fact shared by many. This is an attempt to simplify the mechanism of debt fund returns, for the benefit of investors.

First, it's important to understand that there are two components of a debt fund’s returns: namely, interest income (also called “accrual” returns), and capital gains. Interest income is fairly easy to understand – if I hold bonds worth Rs. 100 Crores, and the average annual interest from them (expected, in a zero-default scenario) is Rs. 7 Crores, that’s a potential accrual return of 7% (7 Crores divided by 100 Crores).

However, what if one or more bonds in the fund’s portfolio default (a fairly common occurrence, mind you!)? In such a scenario, the fund house is mandated to write off the bond as a “non-performing asset”, in tranches, as per guidelines issued by SEBI. This would lead to a drop in the NAV (Net Asset Value) of the fund – plus the 7 Crore interest income that we computed earlier would come down.

The other aspect of debt fund returns (capital gains) is a little tougher to wrap your head around. Here’s a simplified explanation: bond prices, just like stock prices, also fluctuate. Two things cause bond prices to fluctuate – anticipated or actual interest rate movements (for instance, the RBI hikes the repo rate to rein in inflation), or changes in the credit profile of a debt security. If interest rates come down, bond prices go up – and vice versa. Longer maturity bonds are more sensitive to interest rate changes. Additionally - if a bond undergoes a credit rating upgrade from, say, AA to AAA – it’s price would move up, and vice versa.

The metric “modified duration” is an indicator of the quantum interest rate risk that your debt fund has. For example, if a debt fund has a modified duration of 10 years, and rates move up 1%, that’s going to inflict a nasty 10% hit on your portfolio!

Coming back to Rajput’s example – while his fund earned an accrual income of 8% or thereabouts, its likely that it had a relatively high “modified duration”. Since bond yields have gone up sharply in the past year, that would have inflicted a capital loss of around 9% on the fund’s overall portfolio – the net impact being 8% (accrual) minus 9% (capital loss) – that’s a net negative 1%!

End Note:
Debt Mutual Funds aren’t risk-free by any means and should really not be viewed as an alternative to Fixed Deposits. All categories of Debt Funds are not ideal at all points of time. To avoid heartache later, make sure you consult with a professional, competent Financial Advisor before you invest.

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