Decoding debt funds

Even newbie investors are reasonably well aware of how equity funds work. These funds have a mandate to invest in select stocks or sectors, and their performance can be easily gauged against broader market indices like the Sensex or the Nifty. The returns are determined by the funds’ Net Asset Values (NAVs), which can swing up or down, depending on the movement of the prices of stocks in their portfolio.

But not many of us can comprehend the various nuances of investing in debt funds. If you are looking to park some money in debt funds for the first time, it is easy to be intimidated by jargon such as ‘duration’, ‘credit call’ or ‘accrual strategy’, and it makes the process of making an investment decision considerably harder.

But don’t let all the gobbledygook about debt funds inhibit you. Debt funds can be a good diversifier in your portfolio. Here’s some help in decoding some of the key terms used in debt fund investments.

Duration If you thought that debt funds are just like your investments in fixed deposits and cannot erode in value, you’re wrong.

While debt funds may not be as risky as equity funds, a part of your initial investment can erode nonetheless. This is because these funds invest in various fixed-income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments. The NAV of your debt fund can thus rise or fall along with the underlying bond prices.

So what impacts bond prices?

For one, interest rate movements in the economy can impact bond prices. If interest rates move up, bond prices fall. This is because investors flock to newer bonds that offer higher rates. This reduces the attractiveness of older bonds, and so their prices decline. The reverse, too, holds true: when interest rates fall, bond prices move up. In other words, rates and bond prices have an inverse relationship.

Hence in a downward rate cycle, such as we have seen over the past 1-2 years, when the RBI has been cutting its key policy rate, investors have gained handsomely from a rally in bond prices.

And this is where ‘duration’ comes into play. Longer-duration bonds are more sensitive to interest rates; the fund manager of your debt fund will, therefore, increase duration to cash in on the rally in bonds in a falling rate scenario. In a rising rate environment, the fund manager will reduce the duration of the fund, to cap losses.

For instance, top-performing funds such as Aditya Birla Sun Life Gilt Plus-PF Plan, IDFC G-Sec-PF, and SBI Magnum Gilt-Long term plan kept their duration low through 2013, but increased it significantly during 2014 and 2015, to make the most of bond rallies. IDFC G-Sec and SBI Magnum, after intermittently lowering their duration in 2016 to cap possible downsides, have once again increased their duration in 2017 so far, to cash in on the falling inflation scenario, which opened up the possibility of a further rate cut by the RBI.

Thus in a falling rate scenario, it would make sense for you to invest in longer-term gilt funds that primarily invest in government securities. This means that you are betting on ‘duration’.

Accrual strategy or credit call Debt funds can also incur losses if they make wrong credit calls. This is different from the interest rate risk as discussed above.

Some debt funds capitalise on interest receipts rather than on gains from bond prices. This means they earn higher interest by investing in lower-rated (non-AAA rated) bonds. Thus they invest in bonds with different ratings, betting on the credit risk to earn higher interest.

So how can these funds suffer losses?

Since these funds bet on the credit risk of the underlying bonds in the portfolio, a wrong credit call can cost you dear. For instance, if a company that has issued the bond defaults on its interest or principal repayment, the debt fund’s portfolio to that extent is written off. This will impact the NAV of the debt fund.

Even if a bond does not default, rating agencies can downgrade the rating on these bonds owing to several reasons. This can also mark down the value of the fund’s NAV.

Over the past two years, there have been several instances of debt funds taking it on the chin, owing to credit rating downgrades of the debt instruments they hold. In mid-2015, two debt schemes from JP Morgan Mutual Fund took a hit of 2-3 per cent on a single day, when Amtek Auto bonds were downgraded by rating agencies. Similarly, in February 2016, when Crisil downgraded Jindal Steel and Power, the NAV of ICICI Prudential and Franklin schemes fell by nearly 1-2 percentage points.

More recently, four of Taurus’ debt schemes posted a huge loss of 7-12 per cent in a single day after India Ratings and Research downgraded ratings on Ballarpur Industries Limited.

Investors should, therefore, stay clear of funds that have a higher exposure to low-rated debt papers.

Mix and match Debt funds can either follow a strict ‘duration’ or ‘credit’ call or blend the two to come up with different strategies. Long-term gilt funds that primarily invest in government bonds carry a higher interest rate risk. If you want to bet on falling rates, you can invest in such funds. On the other hand, if you are risk-averse and do not want to bet on interest rate movement, you can go in for dynamic bond funds that switch between long- and short-term debt instruments. If you want to take a credit call, there are a host of debt funds, ranging from those investing in low-rated bonds to those that invest in high-rated bonds. You can choose between these funds based on your risk appetite.

All said, as with equity funds, you cannot avoid market risk in debt funds. But given that debt funds have given equity funds a run for their money in good years, it may be wise to allocate a small portion of your fixed-income portfolio to debt funds. But if your idea of fixed-income is to avoid market risk altogether, you may have to make do with good old bank and fixed deposits after all.

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