Most of us are 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 such as the Sensex or Nifty. The returns are determined by their net asset values (NAVs) — which can swing in either direction, based on the price movement of stocks in their portfolio. Simple, right?
But how many of us can say the same for debt funds? If you are looking to invest in debt funds for the first time, jargon such as ‘duration’, ‘credit call’ or ‘accrual strategy’ can easily put you off, let alone help you make a decision.
But don’t let all the gobbledygook about debt funds bother you. Considering that many debt funds have delivered double-digit returns in good years, they are considered a must-have in your portfolio.
Here’s decoding some of the key terms used in debt funds.
If you thought that debt funds are like your investments in fixed deposits and will not erode in value, think again.
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 on your debt fund can, thus, rise or fall along with the underlying bond prices.
So, what impacts bond prices?
For one, the movement of interest rates in the economy can have an effect on them. 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, hence, their prices decline. The reverse holds true under a falling rate scenario; bond prices move up. Thus rates and bond prices have an inverse relationship. Hence, in a downward rate cycle such as now, when the RBI is cutting its key policy rate, investors can gain from a rally in bond prices.
This is where ‘duration’ comes into play. As longer duration bonds are more sensitive to interest rates, the fund manager of your debt fund will increase the 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.
Thus, if rates are falling, it would make sense for you to invest in longer-term gilt funds that invest primarily in government securities. This means 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 interest rate risk, as discussed above.
Some debt funds capitalise on interest receipts more than gains from bond prices. This means that 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 has issued the bond defaults on its interest or principal repayment, then 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, these bonds can be downgraded by rating agencies because of several reasons. This can also mark down the value of the fund’s NAV.
This is what had triggered sharp fall in two of JPMorgan’s debt funds, which had exposure to Amtek Auto’s bonds that were downgraded by rating agencies.
Blending the two
Debt funds can follow a strict ‘duration’ or ‘credit’ call or blend the two to come out 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 choose to invest in such funds. On the other hand, if you wan to avoid risk and do not want to bet on the movement of interest rates, you can go 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 ones that invest in high-rated bonds. You can choose from these funds based on your risk appetite.
All said, like equity funds, you cannot avoid market risk in debt funds. But, as 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. But if your idea of fixed income is to avoid market risk altogether, then you may have to make do with good old deposits after all.