I am planning to invest in a debt/income mutual fund. But I don't understand why returns from these funds fluctuate from time to time even when they invest in fixed income instruments?
Madhumita Bannerjee via e-mail
Indeed, you have a point here. Debt mutual funds do invest in fixed income instruments like government securities, corporate bonds and commercial papers issued by corporate entities, which have a fixed interest rate (coupon) attached to it. Ideally, an investment in a fixed interest instrument should fetch you the guaranteed return on maturity assuming other things remain constant. However, this is not the case. Usually, neither mutual funds hold these securities till maturity nor interest rates remain constant over a period of time.
That apart, these fixed interest instruments are also traded in the market. Therefore, their prices change on a regular basis, which make mutual funds susceptible to market risks. Any unfavourable development in the market may affect the fund's net asset value (NAV). Moreover, changes in interest rates also affect the scheme's NAV. When interest rates fall, existing securities with higher coupons become more attractive. Hence, higher demand for these securities push up their prices. And inversely, prices of these securities fall if interest rates move up. Prices of long-term securities generally fluctuate more in response to interest rate changes than those of short-term securities. Thus, funds with larger quantities of long-term paper are more prone to NAV fluctuations when interest rates change.
Let's understand this with an example. Suppose a mutual fund buys a bond for Rs 100 with a coupon rate of 10 per cent. Thus, the fund should get Rs 110 at the end of the year. However, if RBI cuts interest rates, this bond can be more attractive due to the higher coupon it offers and its price will increase to Rs 111.11. Therefore, the NAV will increase. Thus, the fund's return will subsequently increase. Conversely, the return will fall if RBI hikes interest rate.
Government securities are actively traded in the market and are more susceptible to changes in interest rate. Therefore, gilt funds are more volatile than income funds. The NAV of the fund may also be affected if a bond issuing company fails to honour its obligation to pay principal, interest or both. Though government securities, being sovereign obligations, are free of this risk, corporate bonds are not. Thus, if a corporate bond holding of the fund defaults, then it will have its bearing on the fund's return and its NAV will fall. Different types of debt funds will have varying degrees of fluctuation in returns. These fluctuations will be minimal is ultra short-term funds and will increase as the duration of the fund's holding increases.
Thus, returns of fixed income instruments may fluctuate due to the presence of three types of risk—market risk, interest rate risk and credit risk.