Debt Mutual Funds - Tenure, credit ratings are the key

Indian investors prefer investing in debt products like bank fixed deposits (FDs) for reasons such as guaranteed returns (low interest rate risk) and low probability of default (credit risk). In contrast, debt mutual funds have not yet caught up as an investment avenue, mainly because they do not offer guaranteed returns and are volatile in performance.

However, it is important for investors to understand the key factors responsible for such uncertainty or volatility in the performance of debt mutual funds so that they are better positioned to benefit from these funds:

Debt fund valuations: Impact of credit rating and maturity period (duration)
Debt fund valuations depend on the prices of the underlying portfolios of securities, which may fluctuate either way (like stocks) on a day-today basis depending on market dynamics. Hence, the daily net asset value (NAV) of a debt fund may or may not always move upwards. Fluctuation in prices of debt securities leads to volatility in the NAVs of debt funds.
Valuation of debt securities is dependent on the interest (coupon) paid by the instrument and the expected return (yield) from such securities. Here, coupon is pre-decided, while yield is largely driven by market factors like repo rates, liquidity situation, etc. The coupon paid is dependent on two other variables: Duration of the security and the credit rating of the security.

Investors expect higher coupon from securities that have a longer maturity. This is because uncertainty about interest rates rises as the period gets longer. To compensate for the higher risk, higher coupons are offered for long periods. Further, from a credit rating perspective, a higher rated security would offer a lower coupon and vice versa.

Government-owned (sovereign) securities have no default risk. Hence, for a similar maturity period, such a security would offer a lower coupon compared to a AAA-rated corporate security, which in turn would offer a higher coupon than a AA-rated security.

Inverse relationship

Most investors are unaware of the inverse relationship between price and yield of debt instruments: When the price of a security goes down, the yield on the paper goes up. For example, if one buys a debt instrument with a 10% coupon at a price of Rs 100 per unit, the yield is the same as the coupon, that is 10% (coupon divided by the price).
When the price goes down, to say Rs 90, then the yield rises to 11.11% as the same coupon is now available at a lower price. Conversely, if the price rises to Rs 110, the yield drops to 9.09%, clearly indicating the inverse relationship.

To derive maximum benefit from this relationship, one must be invested in long-term debt funds or instruments when interest rates are expected to fall.

Importantly, long-term securities are more sensitive to interest rate movement than short-term securities. Hence, when interest rates rise, short-term security prices decline less vis-à-vis long-term securities.

Debt fund management largely a play on duration in India

Most Indian debt mutual funds prefer investing in the highest rated securities. However, from a credit perspective, there is a separate breed of funds called credit opportunity funds that try to maximize returns by investing in lower rated securities.

Here, the fund manager's skill is in ascertaining the right securities that have minimal probability of default. However, the true skill of a fund manager lies in the call on duration, in other words the direction of interest rate.

If a fund manager feels that interest rates are going to fall in the near term, he/she would increase the average maturity (duration) of the portfolio and decrease if he/she feels interest rates would rise.

His/her skill in predicting interest rates and creating a portfolio of securities with relevant maturity (long or short) can earn significant returns for the investors.

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