The key to understanding debt fund returns lies in their management and the nature of their instruments. Unlike fixed deposits, debt funds’ returns depend on NAV fluctuations—rising when the NAV increases and falling when it declines. Kunal Gupta may be surprised to learn that debt instruments in a fund are traded, giving them market-driven prices. Bond prices fluctuate with interest rate changes—when the RBI lowers rates, new bonds offer lower interest, making existing bonds with higher rates more valuable, thus increasing the NAV of debt funds. Conversely, rising interest rates cause bond prices to fall, pulling NAVs down. Additionally, fund managers may sell bonds at a profit when prices rise, further boosting NAV and returns. Just as equity mutual funds depend on share price movements, debt funds’ returns are partly tied to bond price fluctuations. This process of adjusting NAVs to market prices is called ‘marking to market’ in financial terms.The return will depend on market price changes and varies with the type of securities held in the fund. A debt fund holds a number of instruments depending on its type. Shorter duration instruments will witness a lower impact of interest rate changes than longer duration ones. Hence, long-term debt funds, such as income and gilt funds, may be subject to slightly higher level of fluctuation in market prices than the short-term funds.
Debt fund returns come from two sources: interest income and gains (or losses) from price fluctuations. The interest component provides stability, making debt funds less volatile than equity funds, even though their returns cannot be predicted or fixed. Since debt funds invest in fixed-income instruments, they don’t experience the sharp swings seen in equities. Unpredictability isn’t a risk to fear as long as Gupta understands its source. He can invest confidently by choosing a fund that is aligned with his risk profile.
Content courtesy Centre for Investment Educationand Learning (CIEL).
Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.
