Who Stole My Debt Fund NAV? Understanding debt fund returns

Published: April 5, 2021 at 10:51 am

Generally, debt products are expected to have lower volatility than equity mutual funds. However, many investors find that debt fund volatility is a lot higher than what they anticipated. This is because of incorrect expectations and a poor understanding of the factors that influence debt fund returns. In this article, we discuss a simple way to understand debt fund return fluctuations.

About the author: S. R. Srinivasan (SRS) is a SEBI registered fee-only advisor part of the freefincal list of fee-only advisors. He believes in numbers based insights. You can approach him for your financial needs via srinivesh.in. His journey has been documented in previous articles.

His journeyHow I achieved financial freedom and became an Investment Advisor! (part 1) and Factors that helped me achieve financial freedom (part 2). What is Financial Independence Retire Early (FIRE), and what is not? (part 3). He has written about a List of Mutual fund categories that you can avoid! Older readers may also recall a Sep 2016 presentation shared by SRS: Growing Wealth: An engineering approach.

Debt fund screener: The ideas mentioned in this article will help users try to select or study debt funds using our new screener. Now over to SRS.

Two questions from investors provided motivation to describe how return expectations from debt products can be formed in particular debt funds.


  • Question 1: HDFC Short Term Debt Fund gave a negative return in Feb 21. How is this possible?
  • Question 2: Bond funds gave a 9% return last year. Why do you expect returns to be 6% or lower?

The facts mentioned in the questions are indeed correct. HDFC Short Term Debt – NAV on 31 Jan ’21 – 24.90. NAV on 28 Feb ’21 – 24.76. That indeed is a negative return of .56% in a month. If you extrapolate this to a year, it could mean a negative return of more than 6% in a year. We don’t expect this to happen.

SBI Dynamic Bond Fund – NAV on 26 Mar ’20 – 26.93. NAV on 25 Mar ’21 – 29.20. This is indeed a positive return of 9.01% annualized in the last 1 year. However, it is also true that this fund would not give anywhere near this return in the next 1 year. We would see how we can use public data to analyze this. We would use HDFC Short Term Debt as an example; we can do the analysis with funds having durations of more than a year.

Note: This article uses approximations and rough calculations. Since we are comparing the differences between expected and actual returns over many months, the approximations don’t affect the analysis. Please don’t use the approach to make a fine estimation of debt fund returns.

Contribution of coupon to debt fund returns

“Coupon” is the technical term used to denote the interest rate that would be paid by the bond issuer to the bondholder. Debt mutual funds deploy their assets in a variety of bonds. The weighted average of these interest rates would be paid to the debt fund scheme. In most duration based funds, a large part of the returns come from interest payments. In most cases, these interest payments would happen regardless of the conditions in the bond market, availability of less or more expensive bonds, etc.

Yield To Maturity (YTM) is another technical term that specifies the expected interest payments from the bond. For a debt fund, the YTM would be a weighted average of the values of the underlying bonds. This parameter is easily available for debt funds in India. Almost all mutual fund comparison sites feature this value prominently. For our example, this data, and other data that we are interested in, is available from the AMC. The data is available for each reporting period for all the debt funds.

When the NAV is declared, one can expect the value to increase by the daily value of YTM. However, the daily value of the expense ratio is deducted. So a realistic expectation would be for the NAV to increase by Net YTM = YTM – Expense Ratio.

The table below lists monthly NAV changes and approximate net YTM values for the fund for select months. (We use monthly data for easier validation; the data is available from multiple sources.)

Difference between actual return and expected return minus YTM
Difference between actual return and expected return minus YTM

For some months, the actual returns are quite close to the expectations based on net YTM, and in some months, the difference is large. What causes this? We attribute this to the changes in interest rate.

Did the interest rates change? RBI did not change rates

You may have heard that the RBI has not changed interest rates for many months now. This, however, does not mean that there is no change in market interest rates. There are many factors at play here. For our discussion, it is enough to acknowledge that the policy rates – repo rate, reverse repo rate, etc. – are only some of the factors in the market rates. It is not a stretch to say that the changes in bond market rates can be as unpredictable as the changes in equity markets. There are also interest rates for various durations. In general, the rates increase as the duration increases. The rates for 10-year securities would typically be higher than the rate for 90-day securities. The plotting of the rates against the duration gives the famous ‘Yield Curve’.

For our discussion, we would look at the changes in 3-year government securities as these are widely tracked and reported. For a better comparison, we should look at the yields of 1-year and 3-year corporate bonds and government bonds. One could also take the lazy approach of using the yields for 10-year government securities. This is a useful metric and is available for most economies.

There are many sources of this data, including RBI. For ease of use, we take the data from investing.com –  Use the monthly report to get a sense of how the yield has changed over the recent months. Weekly data from RBI –  If you want a view of the data for various durations, you can look at the data here.  We use this data for the analysis.

Contribution of rate changes to debt fund returns

We are told multiple times that debt instruments have interest rate risk. Put simply.

  • The value of an existing debt instrument would rise when interest rates fall and vice versa.
  • The magnitude of the change is directly related to the ‘Duration’ of the debt instrument.

Duration, more specifically Modified Duration, is another technical term.  This basically measures the change in the value of a bond for every 0.01 (1 basis point) change in the interest rates. SEBI categories specify the range of Macaulay Duration for each category.  Our example fund is in the Short Duration category and should have a Macaulay Duration of 1 – 3 years. Modified Duration is an extension of Macaulay Duration. For more details, see: Why you need to worry about “duration” if your mutual funds invest in bonds.

One reason to choose our example fund is that the duration data is available easily for every reporting period. The fund maintains a Modified Duration of about 2.6. So the NAV can be expected to change by 2.6 basis points if the interest rates change by 1 basis point. 

It is easy to see that this indeed happened in Jan ’21. The 3-year g-sec yield increased by about .15. The change in price (and value) due to this practically negated the net YTM, and the fund returned .02 for that month. More tellingly, the yield change was about 0.33 in Feb ’21, and this had a larger impact on the returns, making them negative.

This calculation is quite approximate as we have used monthly values. Debt funds are marked to market every business day, and the impact of bond prices is felt on a daily basis. Additionally, we have also ignored changes in the portfolio. This fund is run conservatively but still has a reasonable change in the portfolio. The scheme has 150-plus securities with an average maturity of 3+ years, and hence a number of securities would have to replaced every month.  The table below provides a fuller picture that includes the effect of both net YTM and rate changes on the returns of our example fund. You can see that within the short sample of 6 months, the impact of interest rate has been positive, negligible and negative.

Table explaining yield changes in a debt fund due to duration risk
Table explaining yield changes in a debt fund due to duration risk

Homework! This article has been written before the end of Mar 2021. The yield has fallen about 10 basis points during Mar. Our example fund could give a monthly return of about 0.6 for the month of March. Please check the actual returns when they are published.

Don’t set expectations based on 1Y and 3Y returns!

With the discussion above, it is easy to see how the longer-term bond funds have stellar numbers for 1Y (and 3Y) returns.  Between Mar ’20 and Jul ’20, many yields decreased by more than 1%. SBI Dynamic Bond fund had a modified duration of 7y and above in the past. So the rate cuts would have boosted its returns by more than 5% in the last year. The explanation is similar for the 3Y returns. There was a further boost due to the rate cuts in 2019 too.  It is very interesting to note the current metrics for this fund:   Modified Duration – 2.95 years,  YTM – 4.88  At least this fund manager is expecting interest rates (yields) to increase rather than decrease!

Summary

  1. Most longer-term debt funds get a steady increase in NAV due to interest payments.
  2. They also get impacts – negative and positive – due to changes in interest rates.
  3. The second-factor results in variations in the returns. Though this is much less than the variations in equity returns, it is non-zero.
  4. If you have selected a fund that is suitable for your horizon and has a good credit quality, you need not be worried about temporary changes in the NAV due to interest rate variations.
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