Debt funds invest in fixed interest-bearing instruments, like government and corporate bonds and money market instruments.
According to the Securities and Exchange Board of India (SEBI), there are around 16 subcategories of debt mutual funds based on different parameters, like maturity and type of securities they invest in. If you are looking to understand the types of debt funds, you can find out more about them here.
Debt funds invest in bonds. But what are bonds? Bonds are nothing but contracts between the issuer and the investors. Here, the issuer can be the central government, state government, public sector entity, or private institution. The issuer borrows the money and promises to repay that amount back after the predefined period.
Bonds have a face value. It is the amount that the issuer will pay at the time of maturity. In the meantime, the issuer makes periodic payments, known as the coupon of the bond. It is defined as a percentage of face value.
For example, if the bond has a face value of Rs. 1,00,000 and a coupon rate of 7%, then the issuer will pay Rs. 7,000 to the investors per year.
Now let’s discuss some important factors that you should understand before investing in a debt fund.
The maturity of a bond is defined as the period after which the issuer of the bond will repay the borrowed money back to the investor. If the maturity of the bond is 5 years, it means the investor will get periodic interest payments from the date of investment until 5 years, and at the end of 5 years, the bondholder will get the principal money back and will stop receiving interest payments. Debt funds have different maturities depending on the bonds they invest in. So, we have to use average maturity as a metric for a bond fund.
Let’s understand average maturity with a simple example.
If a debt fund invests in four bonds with different face values of Rs. 2500, 2000, 3000, and 1000, and the time to maturity for these bonds is 5, 3, 1, and 2 years, then the maturity of the fund is calculated as follows:
Weighted total = 2500*5 + 2000*3 + 3000*1 + 1000*2 = 12500+6000+3000+2000
Average maturity is calculated by dividing the weighted total by the sum of the face value of each bond.
23500/8500 = 2.76 years.
The interest rates keep on changing and as we know bond prices and interest rates have an inverse relation. Changes in bond prices are also dependent on the maturity period of the bond. Thus, funds with low average maturity are less susceptible to interest rate changes and funds with longer average maturity are more susceptible to interest rate changes.
One more important concept related to debt funds is the Macaulay duration. The Macaulay duration is the time required for the principal repayment from the internal cash flow generated by the bond.
Suppose there is a bond with a face value of Rs. 3000 and the coupon rate is 6% then the annual payout will amount to Rs. 180.
Macaulay duration = Face value of a bond / annual interest payout
= 3000 / 180
= 16.67 years
While calculating Macaulay duration, we should actually consider the present value of future cash flows. This will give us a more accurate and realistic idea about the Macaulay duration. Let’s continue with the same example that we have considered above. Let’s assume the bond has a maturity period of 5 years and the prevailing interest rate is 8%.
Now, the Macaulay duration can be calculated as
Macaulay duration = Sum of PV of time-weighted cash flows / Sum of PV of cash flow.
= 12252/2760
= 4.43 years
Each bond that a debt fund invests in has some maturity. The maturity of each bond may not be the same. So how do we find the maturity of the debt fund that we want to invest in?
To calculate the Macaulay duration of a fund we take the weighted average Macaulay duration of each bond.
When categorising bond funds based on their duration, the SEBI specifies the Macaulay duration of the fund. For example, according to the SEBI, the Macaulay duration of the ultra-short duration fund must be between 3 to 6 months.
Yield is the amount that an investor will receive throughout his investment tenure. It accounts for all the interim payments received and is expressed as a percentage.
Yield to maturity is the total return that an investor will get if he or she holds the bond till maturity. It includes all the coupons that the investor will receive. So, it can be considered the Internal Rate of Return (IRR) of the bond.
In the calculation, it is assumed that the coupon will be invested at the same interest rate that is offered by the bond. The primary difference between the coupon rate and YTM is that coupon payments are fixed and do not change due to external conditions, but YTM changes due to external factors.
Let’s take an example to understand this further.
Yield to Maturity (YTM) = [AC+ {(FV-CP)/Maturity}] / [(FV+CP)/2]
Where:
So, from the given information, YTM can be calculated as
YTM = [8+{(100-95)/7}]/[(100+95)/2]
YTM = 8.9%
Here, the value of YTM depends on the current price as well time to maturity. So based on those variables YTM will change continuously.
To understand this concept, we have to understand interest rate risk. Let’s assume that a bond pays a 6% interest rate, and suddenly the central bank (in our case, the RBI) decides to increase the prevailing interest rate to 7%.
Now, FDs will start providing a 7% return. This makes the bond unattractive for investors as it only pays a 6% interest rate. So investors will start selling the bond, and its price will go down. So, interest rate risk can be defined as the risk associated with a change in interest rates.
Interest rate risk for debt funds is measured by modified duration. The Modified duration is shown in years. It shows how much the bond price will change in relation to changes in interest rates. The change in bond price is calculated by multiplying the modified duration by the change in external interest rate. Interest rates and bond prices have an inverse relationship, if the interest rate rises, the price of the bond falls, and vice versa.
Let’s understand modified duration with a simple example.
Modified duration is defined as
Modified Duration = (Macaulay Duration) / [1 + (YTM / Frequency)]
= 4.62 years
Now, let’s assume interest rates increase by 1%.
Change in bond price = Change in interest rate * Modified duration
= 1% * 4.62
= 4.62%
So, the price of the bond will decrease by 4.62% and vice versa.
A credit rating is used as a measure of the risk involved in debt instruments. The right category of a debt fund for your portfolio can be determined by your goals and risk appetite. But how will you quantify the risk involved in debt instruments? Let’s take an example.
When you take a home loan from a bank, the bank examines your creditworthiness. They will check your credit score, which is maintained by CIBIL and a bunch of other agencies. They want to make sure that they are lending to someone who will pay back the money on time.
Just like that, to analyze the creditworthiness of the issuer of the bonds, each bond has a credit rating. Credit rating is a measure that determines if the bond issuer will be able to pay back the investors' money. The higher the credit rating, the safer it is to invest in that bond.
There are agencies like S&P, Moody’s, Fitch, etc. that issue credit ratings to governments and institutions. They range from AAA to D. AAA rating indicates higher chances of a borrower repaying the money, and D, being the lowest, reflects the chances of default by the borrower.
Thus by looking at the credit rating of the bond one can quantify the risk associated with the investment. Similarly, while investing in debt funds check the credit rating distribution of the individual securities of the fund and invest in a high-rated fund if you are a risk-averse investor. Based on the quality of each security, overall credit risk is defined. Based on the duration, interest rate risk can also be present in the fund. You should check both before investing in any fund.
You can analyze the credit risk and interest rate risk of any debt fund in sharpely. Below is the image from sharpely for the SBI long-duration fund, where the interest rate risk and credit risk for the fund are low. You can find many such insights on sharpely.
The Macaulay duration is the weighted average duration before the investor would receive the fund’s cash flow. On the other hand, modified duration is used to gauge interest rate risk. A bond's modified duration measures its price sensitivity to changes in yield to maturity.
Credit risk funds invest in bonds with moderate to low credit ratings. So the returns are higher because of the high risk involved. If you are a risk-averse investor, then you should avoid these funds. But investors with a high-risk appetite can consider these funds. Always consult your financial advisor before investing.
