How variation in interest rates alters the returns in debt funds
ET SPECIAL
Every time there is a fall in the net asset value (NAV) of debt funds, there is renewed panic. The simple question in the investor's mind is: if there is no default and the fund is receiving its interest income, how and why should the NAV fall? A drop in the NAV of a debt fund can trigger alarm and lead to a precipitous closure for some, as happened in 2008. The market risks in mutual funds are not widely understood, leading to accusations that these should have been avoided somehow.Investing in a debt fund is quite different from doing so in a bond or fixed deposit. In the case of a fixed deposit, the investor agrees to an unrealistic freeze in rupee return, in exchange for convenience and simplicity. The government no longer determines interest rates in oureconomy, nor are they dictated by powerful institutions. We have transitioned to a market for interest rates, and this market enables money to be lent and borrowed based on the needs and views of a large number of participants.
In such a market place, there are only prices and clearing. There is no right and wrong. If a borrower is willing to pay 8% for a year, and a lender agrees to it, the exchange of money is cleared at the agreed rate. The borrower needs the money; the lender has the money. The market just brings them together and enables the clearing. Alternatively, the borrower might be in the market today believing that the rates are set to rise and, therefore, wanting to borrow today; the lender might be in the market with a view that rates are set to fall and, therefore, eager to lend. We will never know the motivations, nor will we be able to identify why rates move up or down. At the end of the day, as long as everyone keeps their promise, we have a market where rates are determined efficiently and fairly.
When an investor chooses a bank deposit, he does not select the market. This is the reason he settles for a 4% rate on his savings bank account, while the bank itself would be lending its surplus balance for 8% in the call market. The bank is in the market for overnight funds, lending and borrowing as needed, while the saving bank depositor is standing out, content with a fixed rate. The market does not matter to this simple investor. He may get a lower or a higher rate. He is happy with a fixed rate and unwilling to look beyond.
What happens when such an investor chooses a debt fund? He simply steps into the market place for borrowing and lending. In this market, the rates change dynamically based on demand and supply and the views of various players. What is in the market is what he gets. This investor makes 9% on his liquid fund, when the money market rates are high; he makes 4% on his gilt funds, when the interest rates have risen; he makes 12% on his income fund, when credit spreads fall; and he makes 16% on his short-term fund, when rates correct sharply. Mutual funds are subject to market risk.
A debt fund also pools in money and creates a portfolio much like an equity fund, except that it buys debt securities issued by governments, banks and companies. If a five-year bond is issued at an interest of 10%, and the fund buys it, it earns this interest just like any other investor. However, since a debt fund is an open-ended product in which investors can come and go as they please, it accounts for the interest income on a daily basis. Therefore, the NAV of all debt funds will hold a component that represents this steady accrual income.
This income will come to the debt fund unless there is a default. However, if the interest rates in the market move up to 11%, while this bond continues to pay 10%, you cannot have a market where the same good (same issuer, same structure, same rating, same tenor) has two prices. The old bond is less valuable since it pays lesser than the current market rate of 11%. Its price falls. The NAV has to correct for this new value. This is the market risk in debt funds.
Why do the interest rates change? In the normal course, if market participants expect inflation to change, they will modify their expectations for rates. Or if they desperately need money, they will offer a high rate, as they do in March every year. Or, they may seek a different rate given their preferences arising from their own balance sheets. These changes are anticipated, tracked and acted upon by market participants and reflect in prices.
The rates can sometimes change unexpectedly. Last week, the RBI decided to curb speculative positions that may be abetting the rupee's depreciation against the dollar. It wanted to make the rupee scarce, to arrest its slide. A 2% hike in bank rates and in marginal standing facilities was announced. This hurt liquidity in the market and, in response, the rates went up sharply.
What happened to debt funds? They were holding bonds and debt instruments, including money market instruments that were issued at historical rates. The RBI action also precipitated a change in market expectations, where players began to think that the RBI would increase the policy rates too. An increase in market rates meant that the value of debt securities in the portfolio of debt funds fell. A debt fund's steady accrued income of, say, 2p a day (that is 7.4% a year), may not be enough to cover steep changes in the value of bonds arising from variations in interest rates. However, the steadiness of 2p will also ensure that these losses are recovered over time. The funds with longer tenors have too many cash flows in the future and, therefore, correct more when the interest rates increase. The shorter tenor funds typically correct less when the rates change. However, if the change is both unexpected and steep, as happened on 15 July, the correction is significant. Some investors will continue to dislike market risks and seek deposits; others will take the ups and down in their stride as long as they know the pricing is fair. Each to his own.
Why do the interest rates change? In the normal course, if market participants expect inflation to change, they will modify their expectations for rates. Or if they desperately need money, they will offer a high rate, as they do in March every year. Or, they may seek a different rate given their preferences arising from their own balance sheets. These changes are anticipated, tracked and acted upon by market participants and reflect in prices.
The rates can sometimes change unexpectedly. Last week, the RBI decided to curb speculative positions that may be abetting the rupee's depreciation against the dollar. It wanted to make the rupee scarce, to arrest its slide. A 2% hike in bank rates and in marginal standing facilities was announced. This hurt liquidity in the market and, in response, the rates went up sharply.
What happened to debt funds? They were holding bonds and debt instruments, including money market instruments that were issued at historical rates. The RBI action also precipitated a change in market expectations, where players began to think that the RBI would increase the policy rates too. An increase in market rates meant that the value of debt securities in the portfolio of debt funds fell. A debt fund's steady accrued income of, say, 2p a day (that is 7.4% a year), may not be enough to cover steep changes in the value of bonds arising from variations in interest rates. However, the steadiness of 2p will also ensure that these losses are recovered over time. The funds with longer tenors have too many cash flows in the future and, therefore, correct more when the interest rates increase. The shorter tenor funds typically correct less when the rates change. However, if the change is both unexpected and steep, as happened on 15 July, the correction is significant. Some investors will continue to dislike market risks and seek deposits; others will take the ups and down in their stride as long as they know the pricing is fair. Each to his own.
