How debt mutual funds generate returns
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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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