Debt Mutual Funds - Part 2

Today we will see what risks exists in debt mutual funds. But before, that it is important for one to understand how debt mutual funds are priced and how the NAV is determined.

Let us assume that there is a company called TCD & Co. Let us say that this is rated by CRISIL and ICRA (rating organizations) as AAA (don't worry about what rating is right now. I will write about sometime in the future to explain its significance). For the moment assume that AAA is very safe and there is a high chance of the money that you give as loan to the company will come back to you and also the interest that the company promises to you will be given. Now at this point of time, if the Government were to borrow money from the public they may give 8% p.a. (Ex NSS, NSC etc), probably TCD & Co may have to pay 8.5% p.a. to attract lenders and also since it is not as safe as the Government of India, let us assume that rate of 8.5% p.a. is the market rate for AAA companies.

So, TCD & Co will issue a bond such that if you lend them (read as invest) Rs. 921.65 today, they will return you Rs. 1000 after one year. This means that the return on investment on Rs. 921.65 for one year is 8.5%.

Thus as we move closer to the maturity date, this value of the bond issued at Rs. 921.65 will slowly start increasing proportionately such that the return will always be 8.5 p.a. for the remaining number of days to maturity.

Now comes the tricky situation when the is a increase in interest rates by the Reserve bank of India (we will see in future why the Reserve bank of India changes the interest rates, impact of that on inflation etc). Let us say that the interest rates increase by 0.5% p.a. after 6 months from the date of issue of the bond by TCD & Co.

After 6 months, if there was no change in interest rates, the bond price would have increased from Rs. 921.65 to approximately Rs. 959.2. However, now we have an increase in interest rates. Thus for the same bond to give a maturity value of Rs. 1000 in 6 months (remaining period of time to maturity), this value of Rs. 959.2 (current price of the bond) has to decrease slightly to Rs. 956.9 so that it gives a rate of 9% p.a. for the remaining 6 months. The reason that the bond price has to decrease is because, if the same TCD & Co were to issue a new bond for 6 months when the rates have increased such that the maturity value is Rs. 1000, then it would have priced it at Rs. 956.9.

Similarly if the interest rates had decreased by 0.5 % p.a. then the price of the bond would have increased accordingly.

The rating of the company (AAA for TCD & Co) also plays a big role in the return that a bond returns.

Thus we see that there is an inverse correlation between the bond prices and the interest rates. Similarly the impact of the increase or decrease in bond prices is bigger for those bonds where the time left for maturity is longer i.e. a bond that has 6 months to mature will change much lower than a bond that has 60 months to mature

There the most important factors that decide the price of a debt security are

Prevailing interest rate scenario
Maturity period

Interest rates are not constant at all. They in turn are dependent on a whole range of macro and micro economic factors. Tracking this is a highly complex and sophisticated exercise.

Also as a thumb rule, take the following

1. In a scenario where the interest rates are increasing, the bond prices will fall and the fall will be bigger if the time left for maturity is longer i.e. longer term debt funds have a bigger impact.
2. In a scenario where the interest rates are decreasing, the bond prices will increase and the rise will be bigger if the time left for maturity is longer i.e. longer term debt funds have a bigger impact.
3. If the debt funds invest a significant proportion of the money in instruments that have a relatively poor rating (say A or A- or BBB+ etc) then there is a default risk of the company that borrowed the money not being able to return the money and hence that money is lost.

Thus when the underlying bond prices increase or decrease, the NAVs get affected and therefore the returns from the debt funds also get affected accordingly.

It is essential for investors to match their investment horizon with that of the debt fund and also understand the mix of portfolio to see what can happen in case of change in interest rate during the period of investment.