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Understanding Debt Funds |
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Debt funds (or Income funds) are funds that invest strictly in debt related securities. Unlike any other asset class like equity, debt securities are characterized by the following factors
• Known maturity period
• Known coupon rate (or in common parlance known interest rate)
• Known maturity value
Examples of these instruments include Debentures issued by Corporates, State Governments and Central Government, Fixed deposits, Commercial paper, T Bills, Debentures,
WHY DON’T DEBT FUNDS ASSURE RETURNS WHEN THE UNDERLYING SECURITIES THAT THEY INVEST DO?
Debt funds invest in debt securities where the three factors that govern any investment product are known. Yet they don’t assure returns. Sounds a bit perplexing. Actually it is not. Here’s how
There are several factors that decide the coupon rate for a debt security. Chief among them being
• Prevailing interest rate scenario
• Credit worthiness of the security and
• Maturity period.
Of the above, the first factor i.e. the prevailing interest rate scenario is the most critical and most unknown among the rest.
To give you an example, if the prevailing interest rate scenario (as decided by a slew of risk- free debt securities like the Bank prime lending rate, GOI coupon rate for a similar maturity period) suggests that a risk free security maturing in one year is offering a coupon of around 6% then a similar maturing security offered by a corporate (which theoretically speaking is riskier) has to offer a slightly higher rate else buyers wont find this lucrative enough.
Interest rates are not constant at all. They in turn are dependent on a whole range of macro and micro economic factors. Tracking this is a highly complex and sophisticated exercise.
Fund managers therefore constantly track these factors and attempt to get a grip on the movements on the kind of securities that will offer the best return given the prognosis that the fund manager has arrived at.
The prices of these securities change, based on how interest rates actually unfurl. (More about this later). In a rising interest rate scenario older securities are generally offered at discount as the newer securities get issued at a higher coupon and conversely in a falling interest rate scenario older securities go at a premium as they offer a higher coupon rate than the ones that are newly issued.
Also as a thumb rule, the longer the maturity period, riskier it is and therefore the most volatile. |
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