Debt funds have been sold to a large number of re tail investors in the past two years. The investors who bought on the basis of high returns earned in the past, have lost money in the last one month.Why do debt funds make losses?
How should investors choose?
First, a debt fund is a portfolio of debt instruments. Therefore, the return you earn from such a fund is primarily made up of interest income, which is not accounted for on the day it is received in the bank account, but is accrued every day . In other words, if a debt fund buys a bond that pays 9% interest, it would accrue an interest of 75 paisa every month, or 2.5 paisa every day . The amount that accrues to a debt fund depends on the bonds it holds on a given day . This is why a debt fund's NAV will show an upward slope, unlike an equity fund, which does not earn a regular income. Therefore, the investors who chose a debt fund because it provides a regular income and is less risky are correct in their assumption.
Second, several debt funds are open-ended. This means that the fund manager does not receive all the money he has to invest at one point, nor does he hold all bonds to maturity and sell them when the fund matures. A fund that does this is a fixed maturity plan (FMP). All other funds receive money and service redemptions on an ongoing basis.This means that the investors choose the time for which they want to be invested in a fund.The return they get will depend on the period for which they stay in a debt fund.
Third, debt funds are subject to market risk. This means that they may hold bonds paying various rates of interest, while the market interest rate might be changing. This is the source of `mark-to-market' risk in a debt fund. When interest rates go up, the value of existing bonds in a debt fund falls, and vice versa. A debt fund will rework the value of all the bonds it holds, depending on the current market rates.That is why its NAV moves up and down.
Fourth, the return in a debt fund does not comprise interest income alone. To this income, any gain or loss from the change in interest rates is added. This is why debt funds become very at tractive when interest rates are falling. The bonds they already hold appreciate in value, and this adds to the return for the investor. Any change in market rates impacts a long-term bond with several cash flows in the future, than it does for a short-term bond that will mature in a shorter period.
Fifth, debt fund names are not simple to understand. An investor who chooses to put his money in an open-ended debt fund has three choices. A very shortterm debt fund earns only interest income and, therefore, it would incur low risk. A very long-term debt fund earns both interest and capital gains, and would come with a higher risk.All the funds that lie between these two types are combinations of interest income and gains, complicated further by dynamic bond funds. A simpler way to understand how a debt fund works is to see how its NAV has behaved over a long period of time. Low-risk funds will have a steady growth in NAV; high risk funds will show volatility .The time it takes for a volatile NAV to return to its upward normal slope is the minimum time an investor should stay invested.
While buying debt funds, the investors who do not want markto-market risks should choose the ultra short-term funds, and be content with lower returns.This is a low-risk choice, and investors can stay as long as they wish. Those who like to take a view on interest rates should choose long-term funds. This is a high-risk choice and requires investors to time the market. The investors who want their fund managers to take a view should choose other product combinations that fall between these two extremes.
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