Monthly Archives: August 2022

Debt Mutual Funds an Explainer – Part 1

A debt fund is a Mutual Fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are considered to give stable returns and have less risk compared to equity funds. These are often proposed as an alternate to Fixed Deposits and are advisable to highly risk averse people.

ICICI Prudential Bond Fund is a typical debt fund, its portfolio consists of government securities and top-rated corporate bonds. There is close to zero probability of default on these bonds and thus are quite stable while providing regular returns. At the start of this year (3rd Jan 2022) the Net Asset Value (NAV) of the fund was ₹ 31.87, and just one month later (3rd Feb 2022) the NAV stood at ₹ 31.38. How did the value fell by ₹ 0.50? We know that equity market is subject to market fluctuations and its value can go in either direction but how come value of debt fall? If we keep money in FD, its value is certain to rise then why not in case of debt fund?

To decode the situation let’s try to understand how a bond works. A typical bond is a contract between issuer and the current holder. The issuer seeks funds from the market and in return pledges to pay back certain fixed amount each year and a big final payment on maturity date. The issuer sets a par value of the bond say ₹ 1,000, issuer then pledges to pay a fixed rate say 5% each year, this fixed rate is formally termed as coupon rate. In case of ₹1,000, 5% becomes ₹ 50 which will be paid each year to the bond holder. Finally, issuer also agrees to pay the par value ₹1,00 in our case and at maturity say 10 years from now. The contract is then offered on sale in market and multiple buyers can place the bid to buy it. Let’s suppose a buyer buys this contract for ₹ 1,000 – the buyer will get ₹50 each year and ₹1,000 at end of 10 years, a rough calculation reveals that the buyer got 5% return on their investment by buying the bond. A return of 5% is better than what FD offers and thus a rational investor would prefer to buy the bond instead. Thus, more and more investors would rush to but the bond, but due to limited number of contracts only a few would be able to buy. Limited supply of this bond would create a situation where some investors might also be willing to pay more than ₹ 1,000 to get the bond. By paying more their return would be less than 5% but as long as it is more than FD rate a rational investor would still prefer this bond. If the FD rate is at say 4%, the stable price for the bond will be ₹1,081. On other hand if the FD rates were at 6% a rational investor would only pay maximum ₹ 926 for the contract and it will act as the fair price of the bond. Suppose an investor bought the bond contract at ₹ 1,081 when the prevailing FD rates were 4% but in short time banks started offering 4.5% on FD, the fair value of bond will now be ₹ 1,039, the investor will book a loss of ₹ 42. This is how value of a bond contract can fall and thus the NAV of a fund holding multiple bonds.

As in the example above the bond’s fair value is dependent on the prevailing interest rates in the market. If the interest rates increases in market investors would want better returns and thus would be willing to pay less for bond contracts marking a drop in bond’s fair price. While if the interest rate decreases the bond’s price would experience an upward movement. Thus bond mutual funds although being stable are impacted by change in interest rates.

Mutual Funds v Benchmark Index

How does a mutual fund works? An Asset Management Company (AMC) like Axis Mutual Funds pools money from various investors and manages that money by investing it into different options. All mutual fund have an investment objective for eg Axis Bluechip Fund’s objective is – To achieve long term capital appreciation by investing in a diversified portfolio predominantly consisting of equity and equity related securities of Large cap companies. Each fund is managed by a Fund Manager who decides when and where to invest the pooled amount while aligning to the fund’s objective. There is usually a team of skilled professional who assists the manager in taking investment decisions. AMC takes a cut from the pooled amount to cover its expenses this cut is usually around 0.5% to 2% of total asset under management (AUM).

To evaluate the investment decisions taken by the manager each fund has a benchmark index against which its performance will be compared. Axis Bluechip Fund which is supposed to invest majorly in large cap companies has its benckmark as BSE 100 and NIFTY 50. A manager is doing a good job if he/she is able to generate more returns than the index consistently by taking better investment decision.

Looking it from a different perspective: an investor have a choice to invest in mutual fund and pay for the expense ratio or directly replicate the index for free (or nominal cost) using their money. Rationally they would choose to mutual fund only if it has a proven track record of generating better returns. The difference between mutual fund’s return and index return is known as alpha. Simply put:

Alpha = Fund Return – Index Return

A positive alpha means rational investor should prefer fund and manager is proving his/her worth.

We compared returns of Axis Bluechip Fund to its two benchmarks over a period of 9 years. We defined different periods over while the return will be calculated and compared the number of days when fund had generated more return to days when index had more return. The observations are below:

PeriodBSE 100NIFTY 50
6 months42%44%
1 year33%30%
2 years23%17%
3 years10%6%
5 years0%0%

As per the above table: Historically BSE 100 generated better returns than Axis Bluechip Fund 43% of time (i.e. 43 out of 100 days). This number reduces as we take linger period and eventually drops to 0 if the period is 5 years. The the fund manager is generating better returns almost always in past if the investment period is long enough.