Last Updated on September 27, 2023 at 3:53 pm
In the second part of the introductory series on debt mutual funds, a non-technical discussion of the aspects to consider before buying units of a debt mutual fund. You will be surprised as to how many people buy and then worry about these aspects.
The first part is here: What is a Debt Mutual Fund? -meant for absolute beginners. If you have not read that, I strongly recommend that you do and then head back here.
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In the first part, I had mentioned that debt mutual funds buy bonds, just like an equity mutual fund buys stocks.
A bond is a contract between two parties. The person or agency which borrows money, issues a bond certificate agreeing to pay interest at some defined interval – each month, quarter or year. In the case of a debt mutual fund, the lender is the fund manager on our behalf.
We now know that changes in the credit rating of the borrower and changes in interest rates of new bonds in the market affect the current market value of the bond and therefore the NAV of the mutual fund which holds such a bond.
Assuming that the credit rating and interest rates are constant for a period of time, how does the NAV of a debt mutual fund increase?
To understand, we need to become familiar with a bond concept known the as yield or yield to maturity to be specific. I shall discuss this in detail in the next part of this series. For now, we shall refer to this as the return obtained if the interest payments are reinvested and if the bond is held until maturity.
Here “return” = internal rate of return = IRR =XIRR. If you are curious to know more, you can check out: How to buy tax-free bonds in the secondary market.
If the yield to maturity (YTM) of a bond is currently 10%, then the NAV of a mutual fund will increase by 10%/365 = 0.03% each day. That is the interest payments are factored into the daily NAV. This type of NAV gains is known accrual income and is present in all mutual funds for each business day.
On top of this is the change in NAV due to capital gains
capital gains (when interest rates fall and/or credit rating improves)
capital losses (when interest rates increase and/or credit rating declines).
Here credit rating refers to that of any bond issues by a non-government agency. The credit rating of govt bonds cannot be rated as this is the reference. Of course one can compare credit worthiness of Indian Govt bonds with that of US govt bonds.
Trivia: In the early nineties, the Indian Govt was close to bankruptcy. This is the reason why EPF and PPF rates were 12% then – nothing to rejoice! Read more: The evolution of Public Provident Fund (PPF) Interest Rates
Consider two borrowers A and B. A has a gambling problem and B is clean. If you wish to lend money, who will you lend with peace of mind?
Obviously to B. But B is a clean-cut individual with a high probability of repayment. So he can demand a lower interest rate. If you wish to give money to A, you will demand a higher rate.
Thumb rule 1: Higher the credit rating, lower the returns, but better the peace of mind and vice versa. If PPF rates fall below 8%, we should rejoice at the health of the economy – if
Thumb rule 2: five star rated debt mutual fund could well be taking more risk by buying bonds of lower credit quality. So it is important to ignore these ratings and look carefully.
A debt mutual fund investor should be aware of where a fund is likely to invest before buying fund units. This can be understood with two quantities associated with the debt fund portfolio:
The average maturity
If there are three bonds A, B, and C with tenures of 2,3,4 years and the fund holds 20%, 50% and 30% of each respectively,
The avg. maturity = (2 x 20%)+ (3 x 50%) + (4 x 30%).
The average credit rating. A similar definition but in terms of individual credit ratings of the bonds. A bond AAA rating is more trustworthy (theoretically, did you see/read “the big short”?! ) than a bond with AA or A rating.
Key information
Higher the average maturity, more sensitive the debt fund is to interest rate changes and longer it would take for it to recover.
Why? Suppose you buy in Jan 2017, two bonds 1Y and 10Y.
1Y matures in one Y and 10Y in 10 years.
After 6 months, fresh 1Y and 10Y bonds are available at a higher interest rate. Which are you likely to selll first, 1Y or 10Y?
Obviously 10Y, because you do not wish to earn lower interest income for next 9.5 years. But by the same token, which price will fall more, 1Y or 10Y?
Again it is 10Y. There are other aspects to bond-selling that I will discuss later. For now, all we need to know is,
higher the average maturity (in years) of a debt fund, the more volatile it will be to both interest rate and credit rating changes.
If a 5-year “AA” rated bond is degraded to “BB”, one year after the issue the fall in market value would be higher than for a 1-year bond from the same downgraded issuer.
Both types of risk, interest risk and credit risk co-exists at all times. The primary cause for volatility is demand and supply. Often, more than average buying or selling in anticipation of an event (eg. rate cut) can also change the NAV at a rapid click.
The key takeaway from this post: watch out for the average maturity and average credit rating. This is already at a 1000 words so I will use these two ideas to classify debt funds in the next part, but will conclude with this graph.
Notice that with an increase in average maturity of the debt fund portfolio, the volatility increases. Therefore, I alway recommend sticking to funds with less than 1Y average maturity and good credit quality. One can buy risky corporate bonds via the debt fund route and minimise the associated risk. More on this later.
For the same avg. maturity, there are both low volatile funds and high volatile funds. This is because of the credit quality of the bonds that they hold. If interest rates fluctuated a lot, then so will the NAV. If any of the bonds were upgraded or downgraded, it will show in the NAV.
Even if a fund holds 100% of low-quality bonds and their ratings did not change, and the issuer honoured the interest rate payments, the NAV is unlikely to fluctuate a lot (assuming no abnormal buying and selling).
Volatility here is measured by calculating how much each monthly return deviated from the average return taken over a 3Y period. This is known as the standard deviation.
Trivia: Value Research included the above information after Anish Mohan complained to them citing this post: Dear Value Research, duration matters!
If you do not wish to wait for the next part and learn more right away, do consult these posts:
Debt Mutual Funds: Risk vs. Reward
Debt Mutual Fund Investments: Minimizing Risk
How to choose debt mutual funds with no credit risk and low volatility
Before you judge me too harshly, please note that I have already covered the ideas mentioned in the post before. This is a re-telling for beginners.
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