How Debt Mutual Funds Generate Returns

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How Debt Mutual Funds (MFs) work is easy to understand, once you understand the concepts of accrual accounting and mark-to-market.

A debt FCP invests in fixed income instruments such as corporate bonds, government securities; money market instruments such as certificates of deposit issued by banks and commercial paper issued by various companies.

There is a definite coupon or interest that all of these instruments pay. Thus, this coupon accumulates in the portfolio of a debt fund and is taken into account for the calculation of the daily net asset value (NAV). This accumulation is done proportionally for each day. This is the annual rate divided by 365.

From the limited perspective of interest-only accumulation, an investor’s return on units of a debt fund is the accumulation from point of entry to point of exit.

Mark-to-market

The other aspect is the mark-to-market (MTM). As FCPs are a public investment vehicle, investors can enter and exit on any day. For a fair entry and exit price, it must be based on market levels, i.e. the NAV published daily.

It is called mark-to-market because it represents the price or value that the portfolio would have obtained if the entire portfolio were to be hypothetically sold.

Since prices are subject to change daily, this is in addition to or out of the accumulation of that day. If the market is favorable and bond prices rise from the previous day, that adds to the buildup for the day. If the prices go down, that is subtracted from the day’s accumulation and we get the net return.

Let’s take a simplistic example. There is an MF debt scheme with a corpus size of ₹ 100. The portfolio yield to maturity (YTM) is say 5.5 percent. The YTM is listed in the fund’s fact sheet, available on the AMC website. This YTM is taken as a proxy for the accumulation level.

However, there is a refinement here. Expenses are charged to the plan and the net accrual level is YTM less expenses. The published NAV is net of fees.

Let’s say, in our example, that the expense charged to the fund is 0.5%. Therefore, the net accumulation is 5 percent. Each day the portfolio accumulation level is 5% divided by 365 percent, or ₹ 0.0137 per day.

If the impact of that day’s MTM is positive, based on how bond prices move in the secondary market, you get the cumulative plus the MTM as the yield for that day, which is captured in the NAV.

Basis of obligations

If bond prices fall more than the cumulative, your return is negative for that day. In our example, the accumulation per day seems small. However, it is a function of time. Over a day, it only accumulates ₹ 0.0137 per ₹ 100.

Over three months, it accumulates 1.25 percent and puts the fund in a better position to absorb any adverse MTM shock. Over one year, it is 5 percent.

To understand the impact of MTM, there is a metric called Modified Duration (MD), which is also shown in the fund’s fact sheet.

The MD is taken as a multiplier on the movement of interest rates in the market to assess the impact on the movement of prices, and therefore the net asset value of the fund.

Interest rates and bond prices move in the opposite direction. Assume to understand that interest rates have moved 0.5% in both directions, up and down over one year. If interest rates fall by 0.5%, with a 2-year MD, the fund’s NAV is positively impacted by 0.5 X 2 = 1 percent. If interest rates rise, there is a negative impact of 1 percent. While this is a simplistic example, it does give a perspective on how debt funds generate returns.

The writer is a corporate trainer (debt markets) and author


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