Understanding Debt Mutual Funds

When I started learning about debt mutual funds, they appeared very simple to me. But as I learned more their complexity became clear. People still invest in debt funds based on ill-informed notions like, “around 10% returns without any risk”, which is a complete lie. The main reason for this is there is not much information available, and whatever information is available it is filled with wrong concepts like debt fund being risk-free.

I hope after reading this article you will be well equipped to effectively use debt funds and will be able to answer, what are debt mutual funds? Debt funds invest in fixed income instruments, popularly referred to as bonds. Bonds have fixed maturity and most of them pay interest at a fixed rate. They can be issued by the government, by PSUs or by private corporations. Debt funds hold some bonds until maturity and receive principle + interest and trade others in the market. The risk associated with a debt fund depends on the credit risk (risk of bond issuing authority unable to pay back interest and/or principle amount) and interest rate risk (fluctuation in the market price of the bond in response to the fluctuation in interest rate).

What are debt instruments?

Debt instruments are popularly known as bonds, these are issued by various organizations to raise money in the form of debt, and throughout this article, I will be using both these terms interchangeably. Bonds have a fixed value, fixed maturity date, and a fixed rate at which they pay interest (except in case of floating rate bonds). Unlike equity, bonds are not directly affected by the performance of the companies.

Some basic terminology related to bonds:

• Face Value: This is the actual value of the bond, the principle paid at the maturity is equal to this. Interest is also calculated based on this value. The bond may be sold above or below this value.
• Issue Price: The price at which the issuer sells a new bond. This can be below, equal to, or higher than the face value.
• Market Price: The price at which the bond is currently being bought and sold in the market.
• Maturity Date: The date at which the bond matures and is paid in full to the holder of the bond.
• Coupon Rate: The rate at which interest is paid by the issuer to the holder of the bond.

In the case of floating rate bonds, the coupon rate is not fixed and is declared on fixed intervals, like annually, half-yearly, etc.

Some common examples of debt instruments or bonds are.

Government Securities
Treasury Bills
Commercial Papers
Corporate Bonds

How Debt Mutual Funds uses Bonds?

I have seen some mutual fund distributors using the fact, that most bonds have fixed maturity, to market debt funds as risk free mutual funds. But this can not be any further from the truth. There are two ways in which debt funds uses bonds to generate returns for the investors. Understanding this will clear a lot of doubt regarding the working of debt mutual funds and risk associated with them.

Hold Till Maturity

This is the simplest and easiest way debt funds use bonds. Mutual funds buy bonds when they are issued or buy the bonds which are being traded in the market. Bonds are held till maturity and mutual funds receive interest and face value amount from these bonds

As and when the interest is paid by the bonds it increases the asset value of the funds and your NAV also increases. The interest received is reinvested in new bonds. As long as the bond issuing authority does not default on the payments the risk is quite low. In the case of government, even the risk of default becomes almost nil.

But the problem is this that if this was the only way the return generated would be too low, and the fund would have very low liquidity. So let’s make things a little complex and take a look at another way bonds are used by the mutual funds.

Trading the Bonds

This is where debt mutual funds become a little confusing, not only the bonds pay interest and face value, they can be traded in the market for profit. Let us imagine two scenarios.

• You have a bond that still has a few years to maturity. During these years you will receive Rs 1200 from this bond. But you notice that the current market price for your bond is Rs 1000.
• You came to know that coupon rates for new bonds are going to increase, which means newer bonds will pay more interest. This in turn means that the market price of older bonds will fall. You can sell your bonds now and can buy them back at a cheaper rate later. Or maybe buy the newer bonds with better coupon rates.

What will you do in these scenarios? Sell in both scenarios, sell in one of the scenario or in none of them. Well, it will depend on your investment objectives and your calculations. Now imagine you are a fund manager and the same situations arise, on a much larger scale. The fund manager will also take decisions based on the objectives of the fund, various risk-reward calculations, and market conditions.

This is how debt mutual funds use bonds most of the time. The funds sell the bonds which can fetch a better price than the amount they will receive if they hold these bonds till maturity. Fund managers also do speculative trading of bonds mainly based on the expectation of interest rates falling or rising. They sell bonds whose price they think will fall and buy the bonds whose price they expect to rise.

So your NAVs are not only affected by the interest payment of bonds and their credit default risk. The Navs also fluctuate in response to the rise and fall of the market price of the bonds. The performance of the fund and risk associated with the fund is affected by how much risk the fund manager is taking while trading and how successful he is.

Risk Associated with Debt Mutual Funds

There are two types of risk which affects the debt portion of a mutual fund. Although these affects debt mutual funds the most, but it should be remembered that any mutual fund can have exposure to debt instruments.

The two type of risks are:

• Credit Risk
• Interest Rate Risk

Let’s take a look at these in a more detailed manner.

1. Credit Risk: Credit risk in case of bonds is the risk of bond issuing entity defaulting on these bonds, i.e. at the time of maturity the issuer of the bond is unable to pay the maturity amount in full. AMC may hold the bond till maturity or sell it to make money, but a prospect of default decreases the market value of the bond and the AMC might not get the full money at maturity. Thus credit risk is at play whether you hold the bond till maturity or you trade it.
The magnitude of credit risk can be determined by the rating given by various credit rating agencies. In the case of RBI and the government “SOV” rating is given, which means a sovereign guarantee, bonds/securities issued by them have the least probability of default. The higher the credit rating, the least is the chances of default thus the least credit risk.

2. Interest Rate Risk: For the sake of simplicity interest rates can be described as the prevailing coupon rates of new bonds. Interest rate changes have a direct effect on the market prices of existing bonds. The market price of a bond is inversely linked to the interest rates, this means that if the interest rate increases the market price of the bond falls and visa-versa. This affects the bond with a longer maturity period more than the bonds with shorter maturity periods.
This is due to what is called opportunity cost. Imagine you have invested in a bond that offers an interest of 5%. After some time the interest rates increase and a newly issued bond of the same maturity period offers 6% interest. Now you are losing an opportunity of earning 1% additional interest. This is the opportunity cost, the longer the maturity period of the bond more will be the opportunity cost lost.

So, in conclusion, debt funds may not be as risky as equity mutual funds but that doesn’t mean that they are risk-free. Any time the credit rating goes down your NAV will be affected. Anytime the interest rates go up your NAV will be affected.

Types of Debt Mutual Funds

I have written an article giving a brief description of all types of mutual funds as per the SEBI categorization. You can read that article here.

In this section I will follow the same SEBI categorization.

Classification Based on Maturity Duration of Bonds

This include three categories of debt mutual funds.

• Overnight Funds
• Liquid Funds
• Money Market Funds

These funds are restricted to invest in debt securities up to a certain maturity. Overnight funds can invest only in securities with maturity up to 1 day, liquid funds in securities with a maximum maturity of 90 days, and money market funds invest in money market securities which have max maturity of 1 year. As there is a clear restriction on the maturity of particular bonds, you can have a clear picture of interest rate risk. But it is still advisable to check the credit risk involved before you invest.

These are my favorite debt funds and they are enough for me, barring some situations I think a retail investor can fulfill their debt portfolio needs with just these funds.

Classification Based on Macaulay Duration of Portfolio.

All the categories in SEBI categorization. of debt funds having the word ‘duration’ in their name belong to this classification. For example, ultra-short duration, short duration, medium duration, etc.

This category confuses a lot of investor. They think just because their is a restriction of 1 year Macaulay duration on portfolio, fund will only have 1 year maturity bonds. This is a mistake, the Macaulay duration of portfolio is calculated by taking into consideration the payment cycle and maturity of all the bonds. Thus even a funds that has to maintain 1 year Macaulay portfolio duration can have bonds of 10 year maturity. This makes it difficult to find out how much interest rate risk is involved. Average maturity and modified duration are a much useful parameter to judge these funds.

I would suggest you select a fund that has a very low modified duration and average maturity of 1/5 or less of your investment period. Also, keep the credit risk as low as possible.

Funds That Invest in Government Bonds

This includes two categories of debt mutual funds.

• Gilt Funds
• Gilt Funds with constant 10 year maturity

Both types of funds invest only in government securities. Gilt funds can invest in govt. bonds of any maturity duration, while gilt funds with constant 10 year maturity have to maintain a 10 year Macaulay duration of the portfolio. Gilt funds with constant 10 year maturity just like funds of second type can invest in govt bonds of any duration as long as they maintain the portfolio Macaulay duration.

These funds have the least possible credit risk, but have very high interest rate risk. These are also among the most volatile debt funds. I personally stay away from these funds, but they can be used with liquid funds to have a blend of a low credit risk fund and a low interest rate risk fund, for long duration investment.

Funds that Invest in Non-Government Bonds

This include three categories of funds.

• Corporate Bond Funds
• Credit Risk Funds
• Banking and PSU Funds

Corporate bond funds mainly invest in corporate bonds with the highest credit rating, and banking and PSU funds invest in bonds of banks and PSU which have the backing of RBI and government. Thus both of these funds have quite low credit risk, but as there is no restriction on maturity duration of bonds the interest rate risk varies a lot among funds. You can judge the interest rate using average maturity and modified duration. Also, check the credit risk, just because these invest in bonds of safer organizations doesn’t mean you can forget about credit risk.

Credit risk funds on the other hand have to invest in bonds of lower than highest rating, also there is no restriction on the maturity duration of the bonds. I have only one recommendation for them, forget they exist.

Floater Funds

These funds invest in bonds with floating rates, as the rate changes frequently they have very low interest rate risk. But there is no restriction on the credit rating of bonds, thus credit risk can vary from low to high. You should check the average credit rating before investing in these funds.

Whatever Goes Funds

Popularly known as Dynamic Funds.

Fund managers can buy/sell bonds of any credit rating and of any duration. That’s it, you can have interest rate risk from low to high and credit risk from low to high.

Forget they exist.

How to Select a Debt Mutual Fund

I have written an article which explains a simple method to choose mutual funds, it covers both equity and debt funds. You can read it here.

But if I have to summarize my approach to selecting debt mutual funds. Minimize modified duration, have a maximum average credit rating, and keep average maturity below 1/5 of the investment period.

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