A beginner’s guide to debt funds

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HIGHLIGHTS

  • If you want to earn a market rate at a low cost, you should be opting for debt funds
  • A debt fund has to declare the value of its portfolio, after costs, every day

NEW DELHI: Investing in a debt fund means you are buying a portfolio of bonds or debt instruments. There are two types of borrowings— a borrower enters into a contract with the lender and takes a loan; or a borrower issues a bond or an instrument, and the lender invests in it. A debt fund only buys the latter.

A debt fund has to declare the value of its portfolio, after costs, every day. This number is the NAV (net asset value). Every holding of the fund has to be accounted for at its current market value. The funds are classified according to what the portfolio holds. A liquid fund invests in very shortterm instruments; a gilt fund in instruments issued by the government; a corporate bond fund invests in debt issued by companies; and so on.

If a debt fund charges an annual fee of half a percent, and lends in the same market as a bank which takes an annual 3% net interest margin before paying the depositor, the debt fund is a better bet.

Buying a bond or investing in a deposit involves holding the instrument to maturity. Unless there is a default, one can expect the interest to come in as promised. Assume we are looking at a three-year deposit or bond offering 7% interest. The cash flows to the investor are ₹7 on every ₹100 invested, until the bond matures when the principal is returned.

We know interest changes, and new borrowings will happen at a different rate in future. But this bond will continue to pay what it promised.

Assume that six months later, interest rates move up. Our deposit or bond is now a 2.5-year instrument, and to borrow for that tenor one has to now pay 8%. New bonds will get issued at that rate. Our older bond or deposit, which continues to run at 7% is now less valuable. The market will mark its price down. In a fair market you cannot have two bonds with same tenor offering two different rates of interest and selling for the same price. The price of the old bond has to fall so that earning 7% on it is the same as earning 8% on the new bond.

This is the mark to market risk in a debt fund. Every time rates move up, older bonds lose value, and every time rates come down, they gain in value. An investor who buys and sells a debt fund, pays the NAV that reflects this market reality. The investor does not earn just interest income, but also gains or loses from the change in the value of bonds. This gain or loss can be higher or lower, depending on how the cash flows in the fund are structured. We measure it with a number called duration. Higher the duration of the fund, greater the mark to market risk.

How should an investor choose? The simplest approach is to look at how the NAV of the fund has behaved over time. A simple graphic plot of the NAV, beginning at ₹10 and growing over time will do. The slope of that line will be upward. The kinks in that line represents the mark to market risk. The time it takes for those kinks to even off, indicates how duration was managed and how long it takes for recovery from any mark to market loss. Smoother the line, lower the kinks, and faster the recovery, less risky the fund.

 

If earning a market rate at a lower cost is your choice, you could opt for debt funds. But take the time to choose wisely without being distracted by pitches about tax, exclusivity, superior strategy or regular dividend.

 

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