In this post, I discuss the basic ideas necessary for a beginner interested in debt mutual funds to get started. I shall keep it short, sticking to the essentials.
Many of you may know that I have a separate category for debt mutual funds. My Book, You Can Be Rich Too For Goal-Based Investing has a more detailed introduction to debt funds, what to look for, how to select them and the different categories of funds available. The hardcover version is currently 23% off, priced ₹307 at Amazon or Infibeam
What is a bond?
A fixed deposit is the simplest example of a bond. The bank needs money to grow its business (this includes lending to others). So it announces a scheme in which you can deposit a sum for a fixed period of time and it offers interest on it. So the bank is in your debt.
As long as you hold the FD to maturity, it does not matter if new interest rates are higher or lower. Even if there is some bad news associated with the bank, as long as it pays your money back + interest, you are fine.
What if you could trade your FD?
Now suppose you can trade your FD to another person before it matures. All kinds of complications ensue. What should be the value at which the FD should be traded? Suppose your FD has an interest rate of 8% and new FDs have interest rates of only 7%, your FD is more valuable and you can demand a higher price for it. If rates keep going down, your FD will fetch you more profit if you choose to sell it.
On the other hand, if rates increase and if new FDs are available at 9%, yours (still at 8%) will become less valuable. So if you sell now, you can only do so at a loss.
If you buy your FD and hold until maturity, there is no problem. However, if you intend to sell it mid-way then depending on current interest rate, you can either profit or loss. This is known as interest rate risk.
Now suppose there is some bad news about the bank. Say it lent money to the wrong people and they refused to pay up. Profits are down and the share price is falling. The word on the street is that your bank is facing trouble and could fold.
Now if you wanted to sell you FD, would anyone buy? Even if they did,would they buy it at the same price that you did? They will demand to pay less. So if you sell when creditworthiness of the borrower is shaky, you will lose money.
On the other hand, if bank's profits are soaring, its bad loans are consistently decreasing, then people would feel more comfortable buying your FD. At this time, you can demand a higher price and sell at a profit.
If you buy your FD and hold until maturity, there is no problem. However, if you intend to sell it mid-way then depending on current credit worthiness of the bank, you can either profit or loss. This is known as credit risk.
There are agencies which offer a letter grade to the credit worthiness of any borrower. This is known as credit rating. For example, your credit rating is given by CRISIL. This is requested by the banks if you ask them for a home loan.
What is a debt mutual fund?
A debt mutual fund invests in a basket of such tradable deposits or bonds. Some bonds can mature in days and some in decades! Some issued by the government, banks, PSU and corporates.
The current worth of a debt mutual fund, represented by its NAV will represent the current market value of the bonds that it holds. So if their market value rises or falls, so will the NAV. Therefore, so will the value of your investment.
As a thumb rule, longer the tenure of the bond, the more sensitive it will be to both interest rate changes and credit. Therefore I have always advocated the use of mutual funds that invest in very short-term bonds.
An absolute beginner interested in debt mutual funds should first try their hand with liquid mutual funds. These invest in bonds that mature on or before 91 days. So the ups and downs in the NAV will be minimal.
In following posts, I shall cover other bond basics like yield, duration and different types of bond investments. Do share this post with anyone who might find this information useful.
As mentioned above, you can consider buying my book for more details about debt (and equity) funds and how to select them.
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