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5 Debt Fund FAQ’s – Answered!

Are debt funds on your mind? Here are five commonly asked questions about fixed income mutual funds, answered

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What are Dynamic Bond Funds? Do they always give positive returns? 

Dynamic Bond funds are debt funds with no fixed mandate when it comes to portfolio duration or credit rating – hence, the term “dynamic”!  And no, they don’t always give positive returns- for instance, the YTD return from dynamic bond funds as a category has been -2.06% so far. The returns from dynamic bond funds hinge largely upon the fund manager’s ability to make the right ‘play’ at the right time – accrual, duration, or credit spreads. A successful dynamic bond fund manager will be able to predict when to switch out of long-term bonds to shorter-term bonds (that is, from duration to an accrual strategy) and vice versa.

How will bond funds perform when interest rates are low and stable? 

When interest rates are low and stable, returns from bond funds will typically be closer to the YTM (Yield to Maturity) of their portfolios, as the mark to market fluctuations in the prices of the underlying bonds will be low. However, bear in mind that interest rates aren’t the sole influencer of bond prices. For instance, a downward sovereign re-rating could cause yields to spike, leading to negative returns from bond funds. Similarly, the selling of bonds by the central bank to stabilize the Rupee could lead to negative short-term returns from bond funds. Longer-duration debt funds will be more sensitive to such fluctuations. To sum up, when interest rates are low and stable, switch to short-term income funds that have a modified duration of a year or so, and generate returns mainly from accruals. Preferably, make sure the portfolio is at least of a moderate credit rating (50% above BBB) to avert rude shocks from bond defaults. 

Will all debt funds give negative returns when interest rates are moving upwards? If so, should I move from bond funds to non-bond funds in such case? 

When interest rates move up, the mark to market prices of bonds fall, impacting the NAV’s of debt funds negatively. The extent of the fall will depend upon, among other factors, the average maturity of the bonds in the portfolio, and the modified duration. The “modified duration” of a bond fund represents the sensitivity of a bond fund’s NAV to changes in yield. For instance, if a fund has a modified duration of 8 years, and yields rise by 100 basis points, it will have a negative impact of 8 per cent on its NAV (and vice versa).  If you’re concerned about rising interest rates, there’s no need to switch out of bond funds altogether – simply switch from higher duration funds to lower duration (<1 year) ones.

I’m confused! How can debt fund returns be greater than its portfolio yield to maturity? 

The bond fund’s YTM or “Yield to Maturity” is (especially for longer-term debt funds) really just a notional figure. YTM is the return that the fund will realise if all the current bonds in its portfolio are held to maturity; this has a less than slim chance of happening for long-term/ actively managed debt funds. Bond funds make returns from accruals and capital gains. For example, let’s say that a fund has a YTM of 7.08% and a modified duration of 8.51 years. Let’s assume that you invest Rs. 100 in this fund for a year, and accruals contribute Rs. 6.5. In the meantime, say that inflation is magically reined in and yields fall by 100 bps in the next 12 months. This fall of 100 bps in yields will lead to an average increase of Rs. 8.51 in the portfolio of bonds (as indicated by the modified duration). Your total returns (capital gains plus accruals) will be a spectacular Rs. 15 on an investment of Rs 100 or 15%.

The reverse applies too! If yields were to rise by 100 bps in the next twelve months from today, the accrual income of Rs. 6.5 would be completely offset by the mark to market capital loss of Rs. 8.5, and your one-year return from the fund would be closer to -2 per cent.

If I hold a bond fund for 10 years; assuming there is one upward and one downward interest rate cycle, will the fund returns be equal to its yield as of date?

Not necessarily, as the debt fund’s portfolio will be dynamic. Profits (and losses) will be booked from time to time. As mentioned earlier, the YTM is only a representation of the present portfolio, which might just undergo a complete overhaul in the next quarter. The fund returns over a 10-year period will hinge largely on the portfolio buy/sell decisions taken by the fund management team during this time.

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