My Tenth Cent

Debt Mutual Fund is the boring sibling of equity mutual fund; but the more stable sibling as well. In the initial days, the picture of mutual funds, in my mind used to be high risk and high returns. For some of you mutual funds may mean excitement of making money. For someone else it may mean fear and uncertainty. But with regard to debt mutual funds, you don’t need to be excited or afraid. Like I said, Debt Mutual Fund is the boring sibling in the mutual fund space. But nonetheless very important to have a place in your portfolio. 

This 3 part series will give you a good overview of:

• The dynamics of debt mutual funds
• Types of debt mutual funds
• Lessons from the recent credit crises; and
• Managing risk & strategies to invest in debt mutual funds

I am presuming you have a basic working knowledge of mutual funds. If not please visit AMFI Investor Corner for more information about mutual funds.

This article is the first part in the series and will give you an overview of the dynamics of debt mutual funds.

You may also alternately watch the video on our YouTube channel covering the basics of Debt Mutual Funds:

Debt mutual funds : Overview & Dynamics

Debt mutual funds account for ~50% of the overall mutual fund investments. This makes debt mutual funds the largest investment segment with both individual and corporate investments.

In size, debt mutual funds space is over INR 12,98,000 crores (~USD 175 billion). So any serious investor cannot afford to ignore debt mutual funds. But before investing you need to have a basic understanding of the dynamics of debt mutual funds. 

You need to have an understanding of

1. Fundamental aspects of debt mutual funds; and
2. Risks in debt mutual funds

Fundamental aspects

• Regulator: SEBI (Securities and Exchange Board of India). The mutual fund industry is well regulated by SEBI. SEBI is one of the most powerful regulators in the world. This is because common people like you and me invest our money in mutual funds.
• Invest in Bonds. Debt mutual funds invest in bonds issued by borrowers.
• Bonds are typically rated. A rating agency such as  CRISIL, ICRA or CARE rate the bonds. The rating is an indicator of the quality of the bond.
• Borrowers include, Companies, Public Sector Undertakings, Central / State Governments and Banks & Financial Institutions.
• Bonds issued by Central / State Government are commonly referred as G-Secs. G-Secs form the largest segment of debt mutual funds. The non-G-Sec market, which is the rest of the market has been growing steadily over the last many years.

Risks in debt mutual funds

There are basically 3 risks in debt mutual funds:

1. Credit Risk

Debt mutual funds invest your money into bonds. Bonds issued by Companies, Financial Institutions and Government of India. So your returns depend on these borrowers repaying interest and principal on time.

Now if a borrower defaults on payment then your investment is at risk. This risk of borrower default is credit risk. 

If you invest directly in the bond of company, you bear 100% of the credit risk. But a debt mutual fund invests in many bonds. So when a single bond defaults you do not loose 100% of your investment. Only a part of your investment gets affected.

In the last few years, we have seen defaults by several large high-profile companies. These defaults have shaken the notion that you can never loose money in debt mutual funds. Part 2 of this series covers these defaults in greater detail.

So how can you figure out the credit risk of your investment portfolio of debt mutual funds? 

The Credit Rating of a bond is a good indicator of credit risk. Credit Rating ranges from AAA, AA, A, BBB and downwards with D standing for default. AAA is best quality indicating the safest risk on the spectrum. AAA bonds also have lowest interest rates so the returns on your investment will also be on the lower side.

You can refer to the portfolio of your debt mutual fund scheme to get the credit rating of the bonds the mutual fund has invested in.

2. Interest Rate risk

Most common people do not know about interest rate risk.  So it is common to wonder why do returns fall in spite of a portfolio of AAA bonds.

Interest Rate Risk and Credit Risk are the 2 key principles on debt mutual funds that you need to know.

So let us understand interest rate risk in detail.

Components of interest rate risk:

Interest rate risk is a function of 3 components:

1. Interest rate that your bond pays
2. Interest rate movement in the economy; and
3. Time period of your bond

Example:

Let me illustrate with an example.

Let us assume you have INR 10,000 to invest. You invest it in fixed deposit with a bank at 8% per year interest rate for 3 years. This means you will get 8% or INR 800 every year for the next 3 years.

Now let us now assume that 6 months after your investment, interest rates in the economy go down. Your bank now offers only 7% for a fresh 3 year deposit. Such interest rate movements are very common. Banks change the interest rates they offer on deposits from time to time. Would this reduction to 7% per year affect your deposit created earlier at 8%? The answer is No. You will continue to get 8% per year return on your earlier deposit till maturity.

So interest rate movements do not affect deposits already created. But in the case of bonds, interest rate movements will will affect bonds. Instead of a fixed deposit, if you had invested INR 10,000 in a bond, change in interest rates will affect your investment.

Why does interest rate movements affect bond prices?

This is because unlike deposits, bond is a tradeable instrument. That means you can buy and sell bonds the way you buy and sell shares in the stock market. 

Example:

Lets go back to the example given above. You invest in a bond paying 8% per year interest. Later on the interest rates fall and new bonds give only 7% per year interest. Now remember, you can buy and sell bonds like the way you buy and sell shares. And your bond now pays 1% per year more than what is available in the market.

So now more people should have interest to buy your bonds because it pays 1% more than market rate of 7%. Because of the higher demand, the price of the bond goes up and you now make a profit on your bond.  Vice-versa is also true. If interest rates were to go up then people will not buy your bond because they can get better rate in the market. So unless you reduce the price of your bond and take a loss, they will not buy your bond.

So in summary interest rate movements in the economy impact bond prices. If interest rate goes up, bond prices fall and if interest rate goes down bond prices rise. Correspondingly your profit and loss on the bond. 

We have now understood the first 2 components of interest rate risk. Interest rate that your bond pays vs interest rates in the economy.

Now the third component is time period of your bond. This will determine the extent of the impact. By how much the bond prices can move.

Example:

Let us go back to our example. Let us assume the residual period of the bond at the time of sale is only 1 year. This means that the 1% per year impact will only be for one year.  But now instead of 1 year if the residual period is 5 years, then what happens? Then the real impact is 1% per year for 5 years i.e. an impact close to 5% overall.

So time period amplifies the impact of interest rate movements on a bond’s price. The longer the period of the bond the larger the impact of interest rate movement. In technical language interest rate risk is denominated by Duration of the bond. You can check the prospectus of any debt mutual fund scheme and you will get this number.

Remember, the longer the duration, the larger the impact on bond price. So when interest rates in the economy rise and prices of bonds fall; bonds with longer duration takes a higher loss.  

So in summary whenever you invest in a Debt Mutual Fund, you should focus on Credit Quality and Duration.  This is easily available on websites such as MoneyControl and ValueResearch. 

3. Liquidity Risk

Many investors never cared about this risk; until recently when defaults started happening. 

So, what is liquidity risk and how concerned should you be ?

Let us assume you have invested in a debt mutual fund scheme. Now one day the fund manager comes to know that one of the companies is not doing well. So the fund manager decides to exit exposure to that company.

But how does a fund manager exit an investment ?

• One way is to wait till maturity date of the bond when the company should repay you but that may not anymore.
• Alternate way is to find a buyer for the bond in the open market. Now if the market also has the same view as your fund manager, then your fund manager will struggle to find a buyer.

This risk is called liquidity risk. The risk of not having a buyer for your investment when you want to sell. 

The impact of liquidity risk depends on the seriousness of the situation. It can range from having no buyer to buyers willing to buy at a much higher price / loss to you.

Example:

Ballarpur Industries, is one of the largest manufacturers of writing & printing paper. This Company is in the midst of bankruptcy proceedings since 2018-19. But problems started cropping up much earlier. Reliance Mutual Fund is reported to have sold exposure to Ballarpur Industries at a significant loss. Another example is DHFL Pramerica Ultra Short Term Bond scheme. This scheme is reported to have had exposure of close to 3% to ADAG Group. Later when ADAG Group defaulted, the scheme could not exit ADAG exposure.

The impact of liquidity risk to a mutual fund scheme can range from minor loss to full shut down.

What happened to Franklin Templeton debt mutual fund schemes are an example of full shut down. Let us say a debt mutual fund scheme faces default or rating downgrade in a large part of its investment portfolio. In such a case many investors will want to exit their investments in this scheme.  Hence the investors will ask the mutual fund to redeem their investments and pay them their money. This is called redemption pressure.   

When a scheme faces redemption pressure, it is often not able to sell the bonds in default. This is because there may not be enough buyers for a bond in default. So the scheme will need to start selling its good bonds to meet the redemption pressure. As a result the overall portfolio quality of the scheme goes down. If the scheme is still unable to meet redemption pressure, then it will have to suspend redemptions. This is what happened in the Franklin Templeton saga which I will cover in another article soon.

So liquidity risk can be a minor issue or a major issue triggering full shutdown. So when you invest in a debt mutual fund scheme you should be mindful of this risk. Part 3 of this series will cover strategies to manage this risk.

Conclusion

With this we conclude part 1 of this 3 part series. If you were new to debt mutual funds, I hope this article has given you a good starting point. If you were familiar with debt mutual funds, then I hope this article has been a good refresher of concepts.

Before you move to the next part, why don’t you check out the Fact Sheet of HDFC Short Term Debt Fund as an example.  The sheet lays out the concepts covered here i.e. portfolio quality & duration. In this fact sheet you may note that AAA bonds account for ~70%  of the portfolio (AAA 53.99% + Sovereign /Government of India 15.98%).  Duration is 2.18 years. This means the portfolio is less susceptible to interest rate movements. You can find such information on any of Money Control, Value Research or Morning Star or any of other such similar websites.

In part 2 of the series we will cover the various types of debt mutual funds.