A primer for investing in debt mutual funds

Investing in Debt Mutual Funds & Fixed Deposits = You are basically a money lender in disguise!!

Debt mutual funds at a very basic level are similar to Fixed Deposits. In both cases every time we invest our money, we are actually lending out our money indirectly to a borrower (the government/banks/companies/other people like us) who need money. The borrower promises to payback the borrowed money after a certain period of time and also pays interest regularly on the borrowed money.

This lending activity if to be done by us would involve a lot of effort and time consuming activities such as finding the right borrower, collecting the interest payments, ensuring he doesn’t run off with the money etc. In other words, if we were to do this on our own, we would be called a moneylender and is a pretty tough job!!

To help us out in our money lending activities, banks and mutual funds stepped in and became the intermediaries thereby connecting us (the lenders) and them (the borrowers). These intermediaries take some charges for their services and pass on the interest paid by the borrowers back to us.

When Banks are the intermediaries, our lending activity is called investing in Fixed Deposits. When Mutual Funds are the intermediaries, our lending activity is called investing in Fixed Income Mutual Funds. As simple as that.

The key is to remember is that, though we call it investing, we are also indirectly lending!!

Now, while at a broader level Fixed Deposits and Debt mutual funds seem to be similar, there are also some subtle differences which we must be aware of before making a choice between the both.

Let’s explore these differences..

1. Safety of capital – evaluating credit risk

As someone who invests in an F.D, though you are indirectly lending money, you don’t generally need to be bothered about the borrower as the risk is born by the bank and your invested original amount and interest income is almost guaranteed. While theoretically a bank can still become bankrupt, the probability is very low in the Indian context. That being said if you invest large amounts in Fixed deposits, its prudent to choose a reputed, well capitalized bank with strong balance sheet and low NPAs. Worst case, if a bank defaults or goes bankrupt then each depositor in a bank is insured up to a maximum of Rs 1 lakh for both principal and interest amount held by him.

But in the case of a debt fund, there is a slight difference. In debt funds, if the underlying borrower defaults on the interest or principal then the loss is directly passed on to the investor. Or in other words, in an FD our risk is on the bank while in a debt fund our risk is directly dependent on the underlying borrowers. This risk is called “credit risk”. 

Most of the debt funds comfortably reduce/manage this credit risk by diversifying across several borrowers and sectors, conducting thorough analysis on the ability of the borrower to repay, sticking to high quality borrowers, evaluating credit rating of the borrower (rating provided by credit rating agencies and internal teams within fund houses), ensuring security and collateral etc.

However that being said, as prudent investors, we must also have a hang of whether the debt fund is undertaking any credit risk by choice.

But how in the world will we be able to evaluate each and every borrower that the mutual fund has lent our money to. To our rescue come the credit rating agencies (CRISIL, ICRA, CARE and Fitch). These are neutral agencies which evaluate and rate every debt security based on their ability to repay the interest and principal. The rating scale range from ‘highest safety’ denoted by the symbol AAA to potential ‘default’ grade which is represented by a D symbol

Source: CRISIL

The below table shows the percentage of defaults and downgrades (moving to a lower credit rating scale) under various ratings from 1988 to 2015

Source: https://www.crisil.com/pdf/ratings/CRISIL-Default-Study-2015.pdf

Government securities (Gilt/Sovereign) are the safest as they have 0% probability of default in practical terms as you are lending to the government. Further as seen above, AAA rated securities historically have never had a default. Further only 2.6% of AAA papers have got downgraded to AA rating in the last 18 years. Thus we can conclude that AAA rated securities  are very safe in terms of safety of capital and payment of interest.

So the higher the % of AAA and government securities in the portfolio of debt mutual fund lower is the credit risk i.e probability of default or downgrade in the fund. Even AA papers are fine to a certain extent.

You can check the fund’s underlying credit quality from morningstar website. See below a snapshot of the fund IDFC SSIF Medium Term Plan. As seen , the fund had almost 98% in AAA securities which means the fund has consciously avoided credit risk in the fund.

Now, you must be wondering if that’s the case then why don’t all the funds invest only in AAA securities and Government securities so that there is no credit risk.Simple, higher rated debt securities pay lower interest rates compared to lower rated debt securities (as a borrower if my rating is not that great I will have to offer a higher interest rate to attract lenders). There are a set of funds who use this strategy of lending to lower rated borrowers (referred to as credit strategy or accrual strategy) to take advantage of the higher interest rates and hence provide higher returns in the fund. Their fundamental belief is that by deploying their own analysis to these lower rated papers they would be able to identify the “cleanest amongst the dirty shirt” and hence provide investors with a higher return.

Since FDs do not transfer the borrower risk to us, we don’t get an option to improve upon the returns irrespective of who the bank lends to as the returns are already fixed. So be it Vijay Mallya or Tata, whoever the bank is lending our money to, we get the same interest rate in FD.

Debt funds since they pass on the interest paid by the borrowers directly to us (post the intermediation charges), provides us with an option of

1. Sticking to high credit quality and have minimal credit risk just like in FD
2. Investing in funds with lower credit quality  (i.e higher credit risk) but also with potential of higher returns if there is no downgrade or default

Now let’s not immediately get into the debate of whether to go for “accrual funds” or not at this juncture (don’t worry we will discuss that in the coming posts). The idea of this post is to appreciate the options available in a debt fund vis-a-vis a fixed deposit.

2. Source of returns

In case of a Fixed deposit, this is pretty straight forward as our returns will be equal to the FD interest rates which are explicitly communicated at the time of investing and are guaranteed.

You can check the lastest FD rates here: http://www.bankfdrates.in/compare-fd-rates/

But how do we find out our expected returns from a debt fund ???

Debt Funds unlike a simple FD return have 2 sources of returns

Debt Fund Returns
=
 Interest from underlying debt securities
+
Price changes in the market value of debt securities
(based on interest rate changes)

1)  Interest from underlying debt securities (pretty similar to FDs)

This is the easy stuff. Debt funds simply collect interest from underlying borrowers (i.e the debt securities) and pass it on to us (investors) after taking their intermediation charges (called expense ratio).

Now how do we find out the interest rate paid by the underlying borrowers in the debt fund. Simple. There is something called Yield to Maturity or YTM for every fund which you can find it in the fund fact sheet or sites like Morningstar, Value research etc. Due to the fear of boring you to death, I am not going into a jargon laded explanation of YTM.

YTM or Yield to maturity  is simply the aggregate interest rate (return) from the underlying debt securities in the fund . The fund will charge an intermediation charge (read as expense ratio) which will be deducted from YTM and the remaining will be added to the fund return.

So the returns to expect from a fund will approximately be = YTM – Expense ratio

{ Remember we spoke about some funds using a credit strategy. A credit strategy helps the fund to get a higher YTM compared to other funds which don’t take credit risk and thus higher returns if there is no default or downgrade  }

Since debt fund NAV (i.e the market price of the fund) is available everyday , the interest income (YTM-Expense ratio) is divided into 365 days and added to the fund NAV everyday.

Everyday Interest Income Received = (Yield to maturity – expense ratio ) / 365 

Let us understand this with an example:

Let us take the example of IDFC SSIF Medium Term Plan

In the above example, 1) YTM is 7.86% and 2)expense ratio is 1.22%

Its reasonable to expect returns around 6.64%  due to interest income from the fund (i.e 7.86-1.22%) and if interest rates stay around the same level.

Therefore the debt fund NAV will move up by (YTM-Expense ratio)/365 i.e (7.86%-1.22%)/365 = 0.018% everyday.

In other words for every Rs 100 invested in IDFC SSIF Medium Term Fund, you will get 1.8 paise added everyday.

But  interest rates (YTM from a fund’s perspective) may change over a period, as it is market driven as it is influenced by RBI Monetary policy, inflation expectations, demand and supply, economic growth, macro factors etc. Depending on whether the interest rate is going down or up, the corresponding returns from interest income also fall or increase.

 Now enters, the second source of return in debt funds which is not available in Fixed Deposits..

2) Price changes in the market value of debt securities (due to interest rate changes)

Debt mutual funds hold a portfolio of debt securities (assume it to be like a loan document which entitles the holder to receive the payment of principal and interest and can be transferred amongst various lenders). Debt funds have to value the debt securities every day based on the current market value. The prices of debt securities are inversely proportional to the interest rates i.e the prices increase if interest rates go down and prices decrease if interest rates go up.

Logic behind the inverse relationship : Assume a company issues a debt instrument in the market that fetches its holder an interest rate of 8%. A few months later if the interest rates in the economy go down, there will be newer debt instruments that would offer a lower interest rate of say 7%. Since these new instruments have a lower return than the 8% interest instrument, the value (market price) of the older paper and correspondingly the net asset value (NAV) of the debt fund that has invested in these papers also goes up.

This change in prices of underlying debt securities is the second component of returns, which either adds positively or negatively to the first component “interest income” returns, depending on whether interest rates are going down or up.

But by what % does the fund NAV move for interest rate change ??

This sensitivity of a fund’s underlying security prices impact to change in interest rate is measured by Modified Duration. Modified Duration is indicated in years and tells us the % change in price returns of the underlying debt securities for every 1% change in interest rates.

Change in debt fund “price” returns = -1*Modified Duration * % change in interest rate

Since price changes of a debt fund is inversely proportional to interest rate changes I have used a negative sign.

Let’s go back to our example of IDFC SSIF Medium Term Plan.

The modified duration is 2.51 yrs. This implies that if the fund YTM moves up by 1% then the aggregate price of underlying debt securities in the debt fund go down by approx 2.5%. Similarly if the interest rate moves down by 1% the price of the debt fund will move up by approx. 2.5%. Thus, modified duration will give estimates of sensitivity of the fund towards every 1% movement in interest rates.

This price risk due to interest rate fluctuations is called “interest rate risk”.

Again just like credit risk, funds have the choice to take up interest rate risk or not. Funds such as Liquid funds and Ultra Short Term funds keep the modified duration very low (typically less than 1 year) and hence don’t take or minimize interest rate risk. Funds like income funds have high modified duration which can be used by investors to take advantage of declining interest rate scenario. There are also “dynamic funds” which keep adjusting modified duration based on the fund manager’s view on interest rates ( low modified duration if they expect interest rates to go up and vice versa). This attempt to improve returns by managing duration over an interest rate cycle is called duration strategy.

Average maturity is another metric which tells you the weighted average maturity of the underlying debt securities in the fund which in turn also indicates interest rate sensitivity. Higher the average maturity higher will be the interest rate sensitivity. But unlike a modified duration it doesn’t give the you the precise sensitivity.

Thus summing it up :

Debt funds have two sources of returns
Debt Fund Returns = Interest Income + Price impact due to interest rate changes

1. Returns from interest income for a fund will approximately be = YTM – Expense ratio
2. Returns from interest rate changes = (-1)*Modified Duration*Change in interest rate

Unlike an FD where returns are fixed, Debt funds can additionally use two strategies to improve returns

• Credit strategy – lending to lower quality borrowers for higher YTM
  Risk – possibility of default of downgrade
• Duration Strategy – managing modified duration at the fund level based on interest rate view
  Risk – Price risk if interest rate call goes wrong

Phew..that’s a long post.

In our next post, we shall see how to choose appropriate funds for our requirements. Till then happy investing folks 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments