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Best Debt Mutual Fund Guide for Beginners | How to Invest in Debt Funds? | What is Debt Fund? - YouTube
Channel: ET Money
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[Music]
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hi
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everyone my name is shankarnath and
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welcome to the eti money debt mutual
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fund video series
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in this collection of videos we should
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present different aspects
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of debt fund investing in a style that
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you're now used to
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with a lot of data insights and
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suggestions which we are certain will
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help you
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improve your investing decisions in this
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first
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of many videos we shall lay the
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foundation as we seek to have a better
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understanding of
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what is the bond how are bonds priced
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what are the different types of debt
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mutual funds
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and more importantly how to look at
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these different debt funds
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on the basis of their investment
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objective investment strategy
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credit risk interest rate risk fund
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performance and other important
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variables
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subtitles curry let's get started
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[Music]
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let's start from the very beginning what
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is a bond
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a bond is nothing but a loan so who
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needs a loan a number of institutions
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borrow money to support their financing
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needs
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these include the central government the
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state government
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banks nbfcs infrastructure finance
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companies
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home loan providers and of course
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regular corporates okay so how does this
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work
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let's simplify this a bit say a company
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company x
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needs a loan of a thousand rupees and
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you would like to lend them the thousand
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rupees
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to equip the transaction company x
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issues a bond
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thereby becoming the bond issuer and
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sets the following terms
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the principal is a thousand rupees the
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terms
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or maturity of the bond is three years
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and the coupon is set
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at seven percent annually which comes to
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seventy rupees per year
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until the maturity of the bond now you
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find this a fair deal and you invest to
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do up the paperwork and become the
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bondholder
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now there are a few things you need to
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know here firstly
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what the bond issuer is offering is
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merely a promise
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a promise that he will pay you a coupon
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of 70 rupees
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for all three years and of course return
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back the premium of a thousand rupees
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a promise means there is no 100
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guarantee here which means
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there is definitely some risk on account
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of the bond issuer not having enough
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money to pay
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some or the entire amount this is what
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we refer to as the credit risk
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now the quantum of credit risk depends
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from company to company
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some companies have very strong revenue
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cash flows and profits
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which means they can service their debt
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obligations easily
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these companies are given the highest
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rating by credit rating agencies
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like crystal care and icra and are
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displayed as
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triple a or a1 plus on the opposite end
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of the stick
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are companies which have shaky
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financials and consequently their bonds
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carry a higher level of credit risk
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these papers are represented by
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descending alphabets and numeric signs
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like double b or b minus or d rated
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instruments
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a second area of consideration relates
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to the trading in bonds
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unlike a loan that you take from a bank
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bonds have a thriving exchange markets
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where debt instruments are bought and
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sold between parties
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in fact the global bond markets are
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currently over a hundred trillion
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dollars
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which is more than twice the size of the
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global equity markets
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the trading in bonds is often done with
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the objective of profiting from the
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bonds capital appreciation
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that is any increase in the value or the
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price of the bond
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but before we get to an understanding of
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how or why the price of the bond
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increases
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let's first understand how bond prices
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are calculated in the first place
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in theory the current price for bond is
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simply the summation
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of its future cash flows discounted back
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to its present value
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and there are just two steps to
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calculating this step one we pen down
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all bond payments that are yet to be
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received which includes the interest
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payments and of course the principal
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and then we have step two wherein we
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calculate the present value of these
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cash flows
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and sum up the numbers let's apply this
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to our 1000 rupee bond that gives us a
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seven percent coupon
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so say today is the 1st of january 2021
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and you need to know the price for bond
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that is going to pay us 70 rupees in
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year 1 70 rupees in year 2
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and 1070 rupees in year three we now
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focus
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on the first of january 2022 entry
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the receivable amount is 70 rupees
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however since we get that after one year
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we discount it with an interest rate say
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7 percent
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so this becomes 70 divided by 1.07 which
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comes to
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65.5 once we do the same calculations
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for year two and year three
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we arrive at today's price of the bond
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that is a thousand rupees
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do notice that we have used an interest
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rate of seven percent
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now we could have used any other number
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but we went for seven percent because
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that's the discount rate that makes the
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present value
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of all the bonds cash flows equal to its
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price of 1000 rupees
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this interest rate or discount is more
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commonly referred to as the bonds
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yield to maturity or ytm it's a term
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that you'll hear
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and see very often when it comes to debt
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funds and will be covered in more
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details in video 2
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of our debt fund series okay now that we
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have some idea of bond pricing let's
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extend our example to a more practical
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scenario
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assume today is 1st of july 2022
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and the rbi governor has just announced
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a reduction in interest rates of say 4
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percent
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this means any new bonds that are issued
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from today onwards are likely to carry
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a lower coupon rate which effectively
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makes a seven percent
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interest carrying bond more valuable to
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an investor so in our example
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since we are in july of 2022 there are
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three payouts that are still remaining
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on our bond
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there is the 70 rupee interest payout
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that's due in six months
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and then there are two payouts of 70
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rupees and a thousand rupees
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that are due in another one and a half
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years when we apply the steps on this
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information we see that the fair value
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of a seven percent coupon bond
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at a ytm of four percent comes to one
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zero seven seven rupees
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which means today if someone offers you
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an amount
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higher than 1077 rupees you have a very
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strong incentive for selling that bond
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and making profits from that transaction
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it's this
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interplay between interest rates bond
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prices credit risks etc
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that investors and fund managers are
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constantly trying to master through
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experience and learning
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and speaking about learning if you are
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keen to build upon your knowledge
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about investing and mutual funds then do
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subscribe to the etimony youtube channel
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and do tap on the bell icon for
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notification alerts
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[Music]
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in 2018 sebi or the securities and
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exchange board of india categorized debt
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mutual funds into 16 categories
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these 16 categories carried a fairly
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clear definition
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of the schemes characteristics in terms
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of the debt instruments they can invest
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into
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but investing in debt mutual funds have
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a lot more factors to consider which
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shall be the focus of our study
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for the reminder of this video with that
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being said
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let's start with the first area that
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needs our consideration and that is
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the investment objectives
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[Music]
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an investment objective is simply the
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goal or reason for which one
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invests in a debt fund most mutual fund
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companies would show an investment chart
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a lot like what you can see on the
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screen right now this chart does make
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sense to an extent especially
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on the application of overnight liquid
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ultra short term low duration and money
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market funds these funds carry a higher
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level of predictability in returns
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and high safety of capital which makes
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them perfect
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for short-term parking of money and cash
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management activities by corporates
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now let's shift our attention to the
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other end of the chart especially
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to the medium to long duration guilt and
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long duration category
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specifically from a returns perspective
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do notice the roller coaster ride
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that these categories have gone through
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over the past 10 years
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in fact the data here shows that a 10
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plus year
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is often followed by a low single digit
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year
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as we saw in 2010 2013 2015 and 2017
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and is very likely going to be the
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scenario in 2021 itself
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now the objective of investing in debt
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is very different from equities
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equities are for wealth appreciation
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while the primary objective of debt
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is and should always be the protection
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of capital and it's probably
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why our research team feels that the
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investment objectives chart
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we saw earlier is not the right way to
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invest in debt mutual funds
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instead we feel investors who prefer
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debt for long-term investing will be
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better served when looking at it as a
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series of shorter periods
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of three to four years rather than one
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big chunk of 10 to 15 years
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this approach of breaking your
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investment horizon to smaller chunks
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offers two big advantages one it gives
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greater protection of capital by
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regulating the risk one takes
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and secondly the flexibility offered by
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this approach
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allows you to take better advantage of
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capital appreciation opportunities
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the understanding of this will get
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better as we move along to other
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sections of this video series
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[Music]
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debt funds primarily follow either of
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these two strategies to generate returns
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an accrual strategy or a duration
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strategy an accrual strategy aims to
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generate steady returns by investing in
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bonds and holding it till maturity
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this means the concept of an accrual
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strategy is centered on receiving
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interest income from the bonds it
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invests in these papers are then usually
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held till maturity
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which means the interest rate risk is on
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the lower side
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liquid funds ultra short-term bonds low
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duration money market funds
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and even the corporate bond funds
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primarily follow the accrual strategy
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outside of mutual funds institutions
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that use the accrual strategy include
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pension funds and insurance companies
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that have longer term commitments and
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invest over very long durations
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often running into decades net net the
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accrual based strategy
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is perfect for investors who require a
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constant return from the debt portfolio
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and are not keen on taking higher risks
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now let's look at the duration strategy
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a fund that follows a duration strategy
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aims to generate returns by
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actively managing the portfolio duration
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the phrase
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actively managing the portfolio duration
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means that money is made by predicting
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interest rate movements and in the
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active buying and selling of securities
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the strategy is employed by long
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duration dynamic bonds and guild funds
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as they aim to sell bonds at a profit
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a profit situation generally arises when
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interest rates fall
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as a drop in interest rates pushes up
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the price of bonds as we discussed in an
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example
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early in this video having said this do
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note that duration strategy funds are
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open to interest rate risks
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which means these funds take losses if
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the interest rates
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start inching upwards rather than going
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down for example presently a number of
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debt fund managers are expecting an
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increase in interest rates
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which is pushing down the price of bonds
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and the navs of most
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long duration funds are down by two to
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three percent
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in such times where interest rates are
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expected to go up
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funds following the duration strategy
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control the portfolio's duration
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by opting for shorter duration funds of
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course it won't be right to presume that
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a fund or the fund manager follows only
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one of these two strategies at all times
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in fact most funds use a blend of both
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the cruel strategy
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and the duration strategy to improve
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their chances of maximizing investor
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returns
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[Music]
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the reserve bank of india uses the
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benchmark policy rate or the repo rate
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to regulate the supply of money in the
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financial system
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this intervention is done to achieve
[720]
multiple objectives like stabilizing
[722]
asset prices
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improving our balance of payment
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situation and of course to boost
[727]
economic growth since these objectives
[729]
are constantly changing
[731]
interest rates are always in a state of
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flux to put flux in numbers in the last
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15 years
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the reserve bank of india has changed
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the repo rate some 50 times
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now we've already established that the
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price of the bond has an inverse
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relationship with the interest rates
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so when the interest rates fall the
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price of the existing bonds increase and
[751]
vice versa
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that's rule number one and forms one of
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the most important rules of bond pricing
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a second rule one should understand is
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the relationship between a bond's
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maturity
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and the risk of interest rate changes
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here as a thumb rule
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longer the tenure of the bond the more
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sensitive it is to interest rate changes
[770]
which means debt funds like long
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duration or guilt funds
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will be more sensitive to interest rate
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changes as compared to short duration
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funds
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like liquid or money market funds in
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fact let's examine both these rules with
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some actual data
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in the table you see now we have
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populated the returns of a liquid fund
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a money market fund a guild fund and a
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long duration fund
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across different time periods do notice
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the relatively low returns volatility in
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liquid and money market funds
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across these 15 years more specifically
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let's look at the performance of the
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guilt
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and the long duration fund in the
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periods when the interest rates were in
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a downward trajectory
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notice here that these funds performed
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exceedingly well in this period
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as the bond prices continued to increase
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as interest rates kept falling
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and on the opposite end were periods of
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rising interest rates which led to low
[823]
and even negative returns in some years
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for investors and fund managers the
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understanding of the interest rate cycle
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is quite important
[830]
and can have a big bearing on what kinds
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of debt funds one should be investing in
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so if we connect this learning with the
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section on investment objective
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it kind of draws down the point that
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when interest rates start falling
[843]
it makes better sense to opt for longer
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maturity bonds
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so as to profit from the appreciation in
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bond prices
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and when the interest rates are likely
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to rise which seems to be the case now
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it seems more prudent to go for shorter
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maturity bonds
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[Music]
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just like individuals are given a credit
[864]
score institutions receive a credit
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rating
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what's a credit rating it's simply an
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opinion by a credit rating agency
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regarding the ability
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and willingness of an entity to repay
[874]
the principal and
[875]
interest on the loan it has taken this
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opinion is based on multiple factors
[880]
which are evaluated by the rating agency
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and include consideration variables like
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the continuity of the business
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the cash flows the accounting quality
[889]
past debt servicing history etc
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and on this basis a score like triple a
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or
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double a or triple b is assigned to the
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bond issuer
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there are a few things one needs to
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understand here firstly it is commonly
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understood that bonds issued by the
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government don't carry any credit risk
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this is true to a large extent which is
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why guilt funds are often labeled as
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funds with low credit risk
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but having said this do note that it's
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not just the guilt category but
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most debt fund categories have a choice
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of investing in government bonds
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and many funds do exercise this option a
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second point one needs to understand
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is that more often than not higher the
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credit rating
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lower is the coupon rate offered by the
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issuer and vice versa
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which means you are likely to find
[934]
higher coupon rates only in papers where
[936]
the credit rating is low or moderate
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as an example let's examine the
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portfolio of the nippon india credit
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risk fund
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the december 2019 top holdings show
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that the fund has invested in many
[950]
corporate papers which are rated as
[951]
double a
[952]
or lower of course these low to mid
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quality papers do carry
[956]
a higher coupon rate as compared to aaa
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funds thereby representing an option for
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the aggressive debt fund investor
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having said this the fund also carries a
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higher level of risk
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which might show up in the form of
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delays in coupon payments
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and even defaults on the part of the
[973]
bond issuer which can have a negative
[975]
effect on the funds anyway
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[Music]
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by now you would have realized that
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performance or returns in a debt fund
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comprises of many internal and external
[985]
factors
[986]
internal factors include the type of
[988]
instruments in the portfolio the
[989]
maturity of the bonds
[991]
the portfolio duration the investing
[992]
strategy etc
[994]
and then there are the external factors
[996]
like interest rates and credit rating
[998]
which do play a big part in determining
[1000]
returns
[1001]
in terms of assessing the performance of
[1003]
debt funds perhaps a good starting point
[1005]
is to map
[1005]
out how different types of debt mutual
[1008]
funds have performed over the past 11
[1009]
years
[1010]
firstly from an average returns
[1012]
perspective we see that debt
[1014]
mutual funds have sort of delivered an
[1016]
annualized return of eight percent give
[1018]
or take one percent
[1020]
in fact with the exception of overnight
[1022]
funds all
[1023]
debt mutual fund categories have
[1025]
averaged and ranged between seven
[1027]
and nine percent in these last 11 years
[1030]
a second point to consider here
[1032]
are the variations in returns again a
[1034]
simple way to view this is by examining
[1036]
the difference between the maximum
[1038]
and minimum annual returns of a category
[1040]
over a number of years
[1042]
the data here shows that and especially
[1044]
in the case of medium duration
[1046]
long duration and guild funds the
[1048]
movement of interest rates have had
[1050]
a big bearing on the annual returns this
[1053]
big variation in the min
[1054]
and max returns strongly supports a
[1056]
suggestion that
[1058]
one might be better off in creating a
[1060]
debt investing strategy
[1061]
as a series of shorter periods rather
[1063]
than one
[1064]
long long-term investment a third
[1067]
consideration when it comes to analyzing
[1068]
the performance of debt funds is the
[1070]
volatility in fund returns
[1072]
often we choose a fund solely on the
[1074]
basis of the returns it has generated in
[1076]
the past
[1077]
this approach can lead to serious loss
[1079]
of capital as some of the data we have
[1081]
shown in this video earlier
[1083]
indicates that the long duration debt
[1085]
funds follow
[1086]
a meandering performance path rather
[1088]
than a steady one
[1089]
in fact one good way to understanding
[1091]
volatility can be the use of standard
[1094]
deviation the data here shows the
[1096]
standard deviation of different debt
[1097]
fund categories around their 11 year
[1099]
average
[1100]
note here that the floater funds and the
[1103]
banking and psu debt
[1104]
funds have a standard deviation quite in
[1106]
line with the shorter duration funds
[1108]
which is particularly interesting and
[1110]
warrants for some further examination
[1112]
which we'll cover in future videos
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[Music]
[1118]
i think by now you would have got enough
[1120]
clues that there is a lot more to debt
[1122]
fund investing than a cursory glance
[1124]
at the performance expense ratio and
[1126]
other peripheral factors
[1127]
in addition to what we have discussed so
[1129]
far it is important for all of us to
[1131]
understand
[1132]
that debt funds cannot be treated as a
[1134]
buy it and forget it instrument
[1136]
there are many factors at play and it
[1138]
becomes all the more important to go
[1140]
deeper
[1140]
and understand specific debt related
[1142]
terminologies like
[1144]
yield to maturity modified duration
[1146]
average maturity concentration risk and
[1148]
many more
[1149]
we'll certainly be covering these terms
[1151]
in future episodes of this video series
[1154]
i hope you like the content of this
[1155]
video and will draw many learnings from
[1157]
the information data and insights
[1159]
presented
[1160]
don't forget to subscribe like comment
[1162]
and share this video with your friends
[1163]
and colleagues
[1164]
thank you for watching and i look
[1166]
forward to catching up with you next
[1167]
week
[1168]
with another insightful video until then
[1171]
mutual fund investments are subject to
[1173]
market risks
[1174]
read all scheme related documents
[1176]
carefully
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