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How debt mutual funds generate returns

Personal Finance

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The functioning of debt mutual funds (MF) is easy to understand, once you get the concepts of accrual and mark-to-market.

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

There is a defined coupon or interest that all these instruments earn. Hence, this coupon accrues in the portfolio of a debt fund and is taken into account for the computation of the daily net asset value (NAV). This accrual is done proportionately for every day. It is the annual rate divided by 365.

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

Mark-to-market

The other aspect is mark-to-market (MTM). Since MFs are a public investment vehicle, investors can come in and exit any day. For an equitable entry and exit pricing, it has to be based on market levels, that is, the daily published NAV.

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

Since prices are subject to change every day, it adds to or takes away from the accrual of that day. If the market is favourable and bond prices move up over the previous day, that much is added to the accrual for the day. If prices move down, that is subtracted from the accrual of the day and we get the net return.

Let us take a simplistic example. There is a debt MF scheme with a corpus size of ₹100. The portfolio yield to maturity (YTM) is say 5.5 per cent. The YTM is given in the fund factsheet, which can be found on the AMC website. This YTM is taken as the proxy for the accrual level.

However, there is a refinement here. There are expenses charged to the scheme, and the net accrual level is YTM minus expenses. The NAV that is published is net of expenses.

Let us say, in our example, the expense charged to the fund is 0.5 per cent. Hence the net accrual is 5 per cent. Every day, the accrual level of the portfolio is 5 per cent divided by 365 per ₹100, which is ₹0.0137 per day.

If the MTM impact of that day is positive, depending on how bond prices have moved in the secondary market, you get the accrual plus MTM as return for that day, which is captured in the NAV.

Bond basics

If bond prices dropby more than the accrual, your return is negative for that day. In our example, the accrual per day seems miniscule. However, it is a function of time. Over one day, it accrues only ₹0.0137 per ₹100.

Over three months, it accrues ₹1.25 per ₹100 and puts the fund in a better position to absorb any adverse MTM shock. Over one year, it is ₹5 per ₹100.

To understand the MTM impact, there is a metric called modified duration (MD), which, too, is given in the fund factsheet.

The MD is taken as the multiplier on the interest rate movement in the market to gauge the impact on price movement, and hence the fund NAV.

Bond interest rates and prices move inversely. Let us assume for understanding, interest rates moved by 0.5 per cent in both directions, up and down over one year. If interest rates moved down by 0.5 per cent, with an MD of 2 years, the NAV of the fund is positively impacted by 0.5 X 2 = ₹1 per ₹100. If interest rates move up, there is a negative impact of ₹1 per ₹100. While, this is a simplistic example, it gives a perspective on how debt funds make returns.

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

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All you wanted to know about 54EC bonds

Personal Finance

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A popular option for saving long-term capital gains tax on sale of property is section 54EC bonds. Investing in these bonds can help you make gains of up to ₹50 lakh per financial year from capital gains tax. However, there is a lock-in period of five years. This used to be three years earlier. These bonds carry interest, which is currently at 5 per cent and is taxable.

While these bonds are effective in saving tax, there is another option to consider. You have two choices: (a) save long-term capital gains tax by investing in 54EC bonds and lock in your money for five years or (b) pay the tax, keep your money liquid, and invest it in avenues yielding higher than 5 per cent.

Let us compare the returns from these two options.

Assume, for instance, that there is long-term capital gains of ₹50 lakh that is taxable, after indexation benefit as applicable. A sum of ₹50 lakh invested in 54EC bonds would fetch a defined return of 5 per cent per year. This coupon/interest is taxable at, say, 30 per cent (your marginal slab rate), ignoring surcharge and cess for simplicity. Hence your return, net of tax, is approximately 3.5 per cent. As against this, if you go for option (b), you pay tax on capital gains, which is taxable at 20 per cent if we ignore surcharge and cess, for simplicity. Subsequent to paying the tax of ₹10 lakh, what remains with you for investment is ₹40 lakh. Let us now look at a few options for investing ₹40 lakh.

Tax-free PSU bonds

Since there are no fresh issuances of tax-free PSU bonds and interest rates have eased, the yields available in the secondary market are lower than earlier. For our comparison, we assume a yield (i.e. annualised return) of 4.25 per cent for investing in tax-free PSU bonds. ₹50 lakh invested in 54EC bonds, compounding at approximately 3.5 per cent per year, grows to ₹59.38 lakh after five years. ₹40 lakh, which is the net amount that remains in case of option (b), invested at 4.25 per cent tax-free, grows to ₹49.25 lakh after five years. Hence, investing in 54EC bonds at 5 per cent (pre-tax) is a better option than paying the LTCG tax and investing the remaining amount.

Bank AT1 perpetual bonds

There is a negative perception about perpetual bonds after the YES Bank fiasco. The risk factors that got highlighted after the YES Bank AT1 write-off have always existed, but came into action and hit investors. Having said that, there are front line banks such as SBI, HDFC Bank and the like that are worth investing in.

The range of yields in bank AT1 perpetual bonds is wide. We assume 7.5 per cent to strike a balance between risk (higher yield but higher risk) and reward (lower yield but lower risk). Taxation at 30 per cent means a net return of approximately 5.25 per cent. Against ₹59.38 lakh in case of 54EC bonds, ₹40 lakh invested at 5.25 per cent grows to ₹51.6 lakh after five years. Though somewhat higher than the ₹49.25 lakh from tax-free bonds, this is lower than the ₹59 lakh from 54EC, bonds making the latter a better option.

Equity

It is not fair to compare investments in bonds with equity. However, to get a perspective we will do a comparison. We will talk of the break-even rate now. Let us say, equity gives X per cent return over five years, and that is taxable at 10 per cent, which is the LTCG rate for equity for a holding period of more than one year. If ₹40 lakh invested in equity yields a return of 9.15 per cent per year pre-tax, which is 8.24 per cent net of tax per year, it grows to ₹59.4 lakh after five years. Hence the break-even rate for ₹40 lakh to outperform ₹50 lakh over five years, at 3.5 per cent net of tax, is 8.24 per cent net of tax.

Conclusion

Equity returns are non-defined and the break-even rate calculated for this asset class to outperform 54EC bonds is 8.24 per cent net of tax. It is difficult for bonds as it will be possible only for a bond with inferior credit quality against a AAA rated PSU one. Equity or a riskier bond not being a fair comparison, it is advisable to save the tax and settle for 5 per cent by investing in 54EC bonds. However, liquidity is one aspect you may keep in mind — investment in 54EC bonds is locked in for five years.

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

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