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How does money in a Debt Fund appreciate?
There are two independent sources of revenue that a debt fund earns :
a) Interest Income
b) Mark to market
a) Understanding Interest Income
When you invest in a Bank/Company deposit it offers you a fixed rate of interest with the principal being returned on maturity. Similarly when a debt fund invests in various debt securities the issuers of these securities offer a rate of interest and the principal on maturity.
The issuers of these securities could either be various corporates like Reliance, Hindalco, ICICI, Bharat Petroleum or the Government of India.
Understanding Interest Income
Say a debt fund with a starting NAV of Rs 100.00 buys a Rs 100 GoI security paying 8.5% interest semi-annually with a maturity of 5 years.
• The debt fund would earn Rs 8.50 annually and get back the principal of Rs 100 at the end of 5 years.
• The debt fund spreads the Rs 8.50 of interest it earns annually over 365 days of the year i.e. it earns Rs. 0.0233
per day.
b) Mark to Market Gain/Loss As interest rates on Bank Fixed Deposits change frequently so do interest rates on debt securities. Interest rates and debt security prices are in fact the two sides in a See-saw. In general, prices fall when interest rates rise and rise when interest rates fall. If interest rates were to decline then newer bonds would be issued at lower interest rates than existing bonds. Consequently old bonds would be dearer and hence prices of these older bonds would rise.
Similarly if interest rates were to rise then the value of old bonds would fall as newer bonds would bear higher interest rates. The traded price of a bond may thus differ from its face value. The longer a bond's period to maturity, the more its prices tend to fluctuate as market interest rates change
Understanding Mark to Market
If interest rates decline and the GoI issues new 5 year bonds at an interest rate of 7.5% it leads to an increase in the value of the old bonds of 8.5%. The price of the old bonds will move from Rs 100 to Rs 105. If the old bonds are now sold the new buyer will receive Rs 8.50 per year for 5 years but will make a loss of Rs 5 on redemption of the principal at the end of 5 years. The investor over 5 years therefore earns Rs 42.50 by way of interest and loses Rs 5 on the principal amount invested giving a return of Rs 37.50 over 5 years which is equal to the new bond's.
Price (A)
Old bond
New bond
105
100
At maturity after 5 yrs
Principal (B)
100
100
Interest earned (C)
42.50
37.50
Total gain (B-A)+C
37.50
37.50
On the day the old bond price is marked up to Rs 105 the NAV of the fund will increase by Rs 5.00 but from that day onwards the daily interest income will decrease from 8.5% p.a. to 7.5% p.a.
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