People say that after having been a good investment option for the past three years, debt mutual funds are not lucrative anymore. The interest rates have bottomed out and so debt funds will lose their popularity.
But to a lay investor these statements raise several questions: What are debt funds', How do they generate returns' Why should debt funds do well when interest rates go down' and Will debt funds really lose their popularity'
Most of the material targeted at investors do not answer these queries. My article is an attempt to do just this.
To start with, although most mutual funds are equated with investments in the stock market, a major part of the mutual funds consists of debt funds — a class of funds that do not invest in stocks. Debt funds are an alternative to bank deposits and other similar kinds of savings instruments. They are a class of mutual funds that invest in the same kind of instruments that your bank invests your deposits in — government securities, corporate debentures and money market instruments.
Debt funds are geared to provide higher returns than bank deposits. But, you may ask, how does a debt fund generate better returns than a bank deposit'
The answer is really very simple: According to the RBI norms, banks have to hold a part of their deposits in cash and with the RBI. This lowers the efficiency with which they can utilise their funds. Also banks have large overheads in the form of branches, operations and other drags such as maintaining minimum capital and meeting priority sector lending targets.
This is why debt funds emerged to provide investors a more efficient and direct access to high yielding bonds and have become the most popular and safe investment choice in developed markets like the US and are becoming popular in India.
But one key question remains unanswered: how do debt funds generate returns'
Debt funds generate returns in two ways. One is by way of actual interest that accrues on various securities and bonds. The other is by the increase in market price of holdings like government securities and corporate bonds. When newer securities and bonds are issued, carrying lower interest rates (as the interest rates have been falling), the market value of the older bonds, carrying a higher interest rate, that the fund had invested in earlier, appreciates.
This increases the value of those investments of the fund. Funds constantly buy and sell their holdings in a market to realise these gains and thus pay out the returns to their investors in the form of dividends or appreciation in their holdings. The NAV is actually the market value of one unit of holding in the fund. So if you find the NAV of your fund going up, your fund is generating positive returns.
Due to these obvious benefits over bank deposits, debt funds have become very popular in the past three years.
(The author is MD, Standard Chartered Mutual Fund. The views expressed in this article are his own)