ELI5: How do debt mutual funds work?

This article discusses how a debt mutual fund works in simple language. The
ELI5 in the title stands for “explain like I am 5”. We all know how a fixed deposit works. The bank borrows money from us and pays interest regularly or upon maturity. This is also how a bond works.

Now consider three FDs of 1Y, 5Y and 10Y durations. Let’s open an FD with a reliable bank or, better still, with the post office (with a sovereign guarantee) and not touch it until maturity. Then there is practically zero risk (unless the currency collapses, but let us not get macabre).

Let us assume that selling these FDs to someone else before maturity is possible. This is possible only with bonds, but let us use FDs to keep things simple. Now, the fun begins!

What price would you sell the FDs if the initial purchase price was Rs. 1000? The price will depend on demand. Suppose your 1Y FD has an interest rate of 5%, 5Y FD (6%) and 10Y FD (7%).

If a new 1Y FD is available at 4%, then you can sell your 1Y FD at a price higher than Rs. 1000. This is because the buyer will receive interest at 5% for the remainder of the FD term. Moreover, the demand for 5% 1Y FDs will be high, and the price could increase as long as the demand is high.

If a new 1Y FD is available at 6%, then you can sell your 1Y FD at a price lower than Rs. 1000. This is because the buyer will only receive interest at 5% for the remainder of the FD term. The demand for 5% 1Y FDs will be low, and the price could keep falling if 1Y FDs are available at rates higher than 5%.

So, the risk increased when you placed your FD in the market for sale. You could either profit or gain depending on the demand for your FD. The price will fluctuate daily.

The same arguments also hold for the 5Y FDs and 1OY FDs. The key difference is that the price of the 5Y FD will oscillate more than the 1Y FD, and the 10 FD will have higher price volatility.

Why? If the bond/FD duration is only 1Y, the interest rate difference between existing and new FDs will not be that high. So, the risk of buying such a bond is low. If it were a 5Y bond, the risk of buying mid-term is higher.

For example, the current 5Y rate is 5.5%. The 5Y bond on sale offers 6% interest. It is a good buy. But what if new bonds are available after the sale for 6.5%? Of course, new bonds could also offer only 5%.  This uncertainty is higher because the bond maturity period is higher. In the 1Y case, the purchased bond will mature in a few months. Here, it would take much longer. Naturally, the uncertainty and, therefore, the price volatility is higher for the 10Y bond.

So, what is a debt mutual fund? Like an equity mutual fund, which predominantly holds stocks, a debt mutual fund holds bonds. The NAV of an equity fund depends on the current market price of the stocks in its portfolio. Similarly, the NAV of a debt fund depends on the current market price of the bonds in its portfolio.

A debt fund NAV changes due to two main reasons: (1) The interest rate of the bonds (which typically always increases the NAV a little each day and (2) the market price of the bonds.

The longer the bond, the more volatile its market price. Similarly the longer the bonds held in a debt funds, the more volatile its NAV

This is known as interest rate risk or duration risk. Like the equity market, participants speculate a lot in the bond market. In the above example, we stated that if a new 1Y FD is available at 4%, you can sell your 1Y (5%)FD at a price higher than Rs. 1000.

Price changes will not wait for new FDs to be released. In the above case, you could sell for a profit if the market expects new FDs to carry lower rates than current ones. So, duration risk is essentially speculation risk or demand and supply risk.

When interest rates are about to increase, the price of existing bonds will fall because of a fall in demand and vice versa.

We can get a reasonable estimate* of this risk by looking at the portfolio’s average maturity. This is the average duration of the bonds in the debt fund portfolio weighted by the amount held.

* This will not work if the fund predominantly holds floating-rate bonds. More on this later.

The second kind of risk is called credit risk.  There is a counterintuitive idea in the world of borrowing. Consider two companies trying to raise money via bonds. One is a rock-solid business with low overheads and good profitability, and the other is a shaky business with losses in the past.

A lender will expect a higher interest rate from a shaky business because of the risk they are taking. So, an entity already losing money is expected to shell out more interest. Things can go wrong. The shaky business can fold, and interest payments will not be made, and worse, the principle will also be lost. Typically, there is collateral, but payback can take forever. Remember, a delay in interest payment is a loss, as time is money. This is the credit risk.

So lenders are given a rating by a firm known as the rating agency. Govt bonds are rated “sovereign”. Short-term bonds from sound non-government borrowers are rated A1, and long-term bonds are rated AAA. It is much like grades in school, with each agency having its own code.

There can be a credit event or credit default. This is when rating agencies suddenly decide that a borrower is no longer reliable in paying interest. The bond’s market price would nose dive as there would be no buyers, and the NAV would take a big tumble, too.

A debt fund holding risky bonds offers higher returns (until they don’t)!

A debt fund holding only government bonds is safe from credit risks. However, if the bonds are long-term, the NAV will be volatile. So, we must look at both credit rating profile and average maturity.

Here are some guidelines for choosing debt mutual funds

1. Liquid and money market funds typically offer low credit and low interest risks. They can be used for short-term needs.
2. As mentioned above, Gilts funds have no credit risk but can have significant duration risk and should only be used for long-term needs.
3. A corporate bonds fund offers a reasonable balance between credit risk and duration. risk

Are debt mutual funds a replacement for fixed deposits? No, they are not. Debt fund returns are market-linked and unpredictable. Sometimes, they can do better than FDs and sometimes not.

Learn more about debt mutual funds:

• An introduction to debt mutual funds for new investors.
• Three Key Mutual Fund Terms All Retail Investors Should Know.
• Debt Mutual Fund Categories Explained For Retail Investors.