Debt funds have been sold to a large number of retail investors in the past two years. The investors who bought on the basis of high returns earned in the past, have lost money in the last one month. Why do debt funds make losses? How should investors choose?
First, a debt fund is a portfolio of debt instruments. Therefore, the return you earn from such a fund is primarily made up of interest income, which is not accounted for on the day it is received in the bank account, but is accrued every day.
In other words, if a debt fund buys a bond that pays 9% interest, it would accrue an interest of 75 paisa every month, or 2.5 paisa every day. The amount that accrues to a debt fund depends on the bonds it holds on a given day. This is why a debt fund's NAV will show an upward slope, unlike an equity fund, which does not earn a regular income. Therefore, the investors who chose a debt fund because it provides a regular income and is less risky are correct in their assumption.
Second, several debt funds are openended. This means that the fund manager does not receive all the money he has to invest at one point, nor does he hold all bonds to maturity and sell them when the fund matures. A fund that does this is a fixed maturity plan (FMP). All other funds receive money and service redemptions on an ongoing basis. This means that the investors choose the time for which they want to be invested in a fund. The return they get will depend on the period for which they stay in a debt fund.
For example, a liquid fund, which is a very-shortterm debt fund, is run like an interest-bearing current account. It invests as it receives money, and the interest income it earns is accrued every day. An investor who leaves idle cash in a savings bank account earns only 4%, but the same money in a liquid fund or an ultra short-term fund will earn a daily interest income based on the market rates. Most investors will find ultra shortterm funds an efficient vehicle for shortterm investments.
Third, debt funds are subject to market risk. This means that they may hold bonds paying various rates of interest, while the market interest rate might be changing. This is the source of 'mark-to-market' risk in a debt fund. When interest rates go up, the value of existing bonds in a debt fund falls, and vice versa. A debt fund will rework the value of all the bonds it holds, depending on the current market rates. That is why its NAV moves up and down. Fourth, the return in a debt fund does not comprise interest income alone.
To this income, any gain or loss from the change in interest rates is added. This is why debt funds become very attractive when interest rates are falling. The bonds they already hold appreciate in value, and this adds to the return for the investor. The extent of this appreciation depends on the cash flow from the bond due in the future. This is why long-term bonds tend to be more volatile than short-term bonds. Any change in market rates impacts a long-term bond with several cash flows in the future, than it does for a short-term bond that will mature in a shorter period.
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