Lets us first understand what makes the NAV of debt schemes move to better understand the actual impact of this move.

WHAT ARE THE RISKS THAT DEBT SCHEMES ENTAIL?


CREDIT RISK:


Mutual Funds invest in debt securities such as Government Securities and Bonds issued by companies. While the Government Securities (or Gilts) are considered risk free on account of credit, they remain highly rate sensitive. Similarly, corporate bonds also react to the rate movements. They however, can also decline in cases of rating downgrades since companies can default on their debt. We saw similar price impacts in past in case of JSPL & Amtek Auto.

Mitigation: Strong fundamental research regarding the underlying papers helps in making the right choices. Along with this the portfolios are managed dynamically to ensure the rebalancing in case of any risk of default.


LIQUIDITY RISK


The fund manager may not be able to liquidate a security due to lack of demand (low volumes) or even inappropriate valuation being offered.

In such cases, the Fund Manager may be forced to hold the security for a longer period than he / she desires. In case of very high redemption pressure, the fund manager may sometimes be forced to sell the security at a low price or may be forced to restrict redemptions. Hence, you may not be able to take out money even if you wanted to.

Mitigation: All the funds, any point in time, maintain sufficient liquid/cash equivalent assets in order to meet the anticipated redemptions.


INTEREST RATE RISK:


A debt scheme is merely a portfolio of underlying bonds. The maturity (or better assessed through 'Duration') is a measure of how sensitive the bond is to movement of market interest rates. The duration of the scheme is the weighted average of duration of underlying securities.


Higher the duration (interest rate sensitivity) of underlying bonds, higher the resultant duration of the scheme. And higher the duration of a mutual fund, the greater the sensitivity of NAV to interest rate movement. In simple terms, if the duration of a debt scheme is 8, the NAV of the scheme will go down by 8% if the interest rate goes up by 1%. On the other hand, if the interest rate goes down by 1%, the NAV of the MF scheme will rise by 8%.


It is however, notable that any adverse impact of duration is more marked to market basis and still reversible unlike credit, where the impact of adverse credit movement can prove to be irreversible.


Mitigation: Backing on strong economic research and macro indicators, the fund house has benefitted from various rate cycles by switching strategies from "accrual to duration" and "duration to accrual" as and when required. Over the past many market cycles

NAV of debt funds can be influenced from external events also apart from domestic factors like inflation, growth etc as they can manifest in any of the above mentioned risks.

For instance, in mid 2013, a number of foreign investors started selling Indian debt heavily on account of Taper Tantrum and resultant risk aversion to all emerging markets including India. Excessive selling put pressure on bond prices as when the supply is high (people are selling) as compared to demand, prices typically go down. NAV of debt mutual funds across categories took a severe beating during the time.

Fund Categories largely differ based on their interest rate sensitivity (measured through Duration) or the average credit quality of the underlying securities that they invest in. Generally, the funds with higher duration or more aggressive credit positioning are the most volatile. As such, during July 2013, many debt funds faced similar NAV impact as in Feb 2017.

Now, what should a normal investor do in such moments of stress? Typically, in the fear of losing more an investor tends to redeem the investments and thus books these marked to market losses. It is important here to note that, the chances of one's capital getting wiped off in a debt scheme are low as long as it is duration driven. The loss, however severe will be notional unless redeemed. Especially, when the economy is stable and bond prices fall due to negative sentiment, one should ideally wait for the fund to recover losses.

Is the recovery possible?

Yes, it is possible for a debt scheme to recover by continuing to accumulate the coupons from various underlying holdings. At the same time as sentiment reverses (for better) and markets recover, the positive movement from bond prices also adds to recovery.

But, how long one must wait before the losses are recovered?

The answer to this question is quite subjective as the time require by different funds will be different. The activity level of fund management also plays an important role in such NAV recovery.

Let's assume Fund A has a YTM of 6% and Fund B has a YTM of 8% & NAV of both the funds suffers due to a market event by 3%.

Now Fund A will recover in 6 month while Fund will make the same recovery in 2-3 months.