FundsIndia Explains: Why debt fund returns are not fixed

Last week, in this column, we explained why equity fund returns are not fixed or predictable. This week, we’ll take up debt funds. You may look in askance if we tell you that debt fund returns are not fixed. After all, they invest in fixed-income instruments. If interest is fixed, why doesn’t it translate to your fund? The answer lies in the way debt funds are managed and the nature of their instruments.

To start with, remember that the way you get returns in any mutual fund, whether debt or equity, is from the change in NAV. The NAV reflects the market value of the instruments held by the fund plus interest or dividend income as the case may be.

Different rates for papers
Now take a debt fund. It holds a number of instruments, depending on the kind of fund it is. The choice ranges from government bonds and treasury bills to certificate of deposits issued by banks, to commercial papers and bonds issued by companies, money market instruments, and such. Not just that, each issuer sets a different interest rate for each paper. Given the enormous number of companies and banks, the range of instruments and their interest rate is huge. Each instrument the fund holds, thus, carries a different interest rate. For example, in HDFC Medium Term Opportunities’ current portfolio, the interest rates on the 100-plus papers it holds range from 7.9% to 9.45%.

Further, all instruments the fund holds do not mature at the same time; i.e., the papers have different maturity dates. There could be a bond that comes up for redemption today, another one that may be due for redemption next month, another in the next week as so on. As one paper matures, the fund will redeploy the proceeds in another instrument.

The interest so collected by the fund increases its AUM and thus its NAV, and thus your return. There is no way to calculate or predict what the overall interest accrued is for the fund, given the variety of interest rates and constant shifting of the portfolio itself.

Market value of papers
Second, the papers a fund holds have a market price and are traded. The NAV reflects this market value. And like a stock’s price changes, the market price of bonds change. A debt fund will have to show the current market value of its portfolio. As prices change, so will the NAV.

Bond prices react to changes in interest rate. If the Reserve Bank reduces interest rates, then new instruments will carry lower rates. The yield of the existing bonds adjusts to this – those bond prices will rise as demand for them goes up. The reverse happens on a rise in interest rate. Similarly, if a company’s credit rating improves, it will be able to get raise debt at lower interest rates. The company’s existing bonds will be at higher rates (since they reflect the poorer credit standing) and thus their prices go up. Several other factors influence interest rates and bond prices, such as liquidity and demand-supply. Given the range of influencing factors, bond prices aren’t predictable either. Nor is the effect they have on the NAV.

Such marking of papers to market value is not required for liquid funds alone.

Selling off papers
Debt funds declare the yield-to-maturity of their current portfolio – which is to say that if the fund held all the instruments that are currently in its portfolio for the entirety of their tenure, its return or yield will be that much. But a fund needn’t hold all those instruments to their maturity. It could well sell off bonds to make money off price appreciation. Duration funds follow this strategy quite explicitly. Besides, as said earlier, instruments mature and make way for new ones, again affecting the yield to maturity.

But while returns cannot be forecast, debt funds are far less volatile than equity funds. Unpredictability of returns is not something to be afraid of. A debt fund still invests in fixed-income instruments and it will not see the swift rises and steep falls that equity is wont to do.