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Want to invest in debt MFs? This is a must read

Posted by: Uma Shashikant on Dec 24, 2018, 07.57 PM IST

By Uma Shashikant

For all the attention equity markets enjoy, bigger action among informed institutional players happens in the debt markets. 

Earlier, retail investors had no interest or direct participation in this segment, except for buying a few bonds to save taxes. Debt fundschanged that equation, but remain poorly understood. 

This column is a primer to demystify debt funds. 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 will only buy the latter. Regulations do not permit debt funds to make loans. Issuance of securities is more transparent than structuring a loan. 

A debt fund has to declare the value of its portfolio, after costs, every day. This number, represented as a per unit value is called the NAV (net asset value, where net means net of expenses). The law requires every holding of the fund to be accounted for at its current market value. Elaborate systems, processes and rules ensure this. Debt funds are classified according to what the portfolio holds. 

A liquid fund invests in very short-term instruments; a gilt fund in instruments issued by the government; a corporate bond fund invests in debt issued by companies; and so on. In a bank deposit, the investor lends to the bank, which uses the money for a fixed period and pays interest. What the bank does, who it lends to, how those investments perform, are all decisions that do not impact the investor directly. 

As long as there is no default, the investor is happy. Mutual fund investors do not have that buffer of a bank’s balance sheet coming between their money and the borrowers’ who are on the asset side. Everything earned on the asset side less expenses, belong to the investor. If a debt fund charges an annual fee of half a percent, and lends in the same market as the bank which takes an annual 3% net interest margin before paying the depositor, the debt fund is a better bet. Consider the thousands of crores that corporate and institutional investors park in liquid funds. They earn interest on every rupee every day. 

Retail investors who cannot access the short-term money markets directly, let their money lie idle in the bank. Since a debt fund has to account for interest earned every day, and offers redemption on t+1 basis, investors can access the market instead of settling for a lower return by going through an intermediary like the bank. There has to be a catch. What is the risk in debt funds? Many give up trying to understand the complexity of the risk of a debt fund. Let’s try our hand at simplifying it. 

Buying a bond or investing in a deposit involves holding the instrument to maturity and earning interest. Unless there is a default, one can expect the stated 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 Rs 7 on every Rs 100 invested, until the bond matures when the principal is returned. Pause to consider why 7%? The simplest explanation is that it is the market rate for a three-year borrowing, when that bond or deposit was issued. We know that interest changes, and new borrowings will happen at a different rate in the future. But this bond will continue to pay what it promised. 

Let’s assume that six months later, interest rates move up. Our deposit or bond is now a 2.5-year instrument, and let’s assume that 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. Who would buy a bond that pays 7% when the market rate is 8%? The market will mark its price down. This is also the right thing to do, because in a fair market you cannot have two bonds with same tenor of 2.5 years, offering two different rates of interest and selling for the same price, say Rs 100. 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. 

A debt fund is uniquely exposed to this risk, because it declares a daily NAV that reflects the value of the bonds it holds. 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. Therefore, the investor does not earn just interest income, but also gains or loses from the change in the value of the 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 Rs 10 and growing over time will do. The slope of that line will be upward, indicating the interest income steadily earned by the fund. The kinks in that line represents 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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