When it comes to debt investments most prefer the safety and familiarity of traditional instruments. Non-traditional debt products like mutual fund debt schemes on the other hand seem confusing and their terminology feels complex.
We will let you on to a little secret. These products are not complicated if you understand their underlying principles. So, this article will focus on demystifying debt basics.
They are three key factors, which influence debt investments – interest rate, duration and credit rating. Having a good grasp of these factors, will help you identify potential investments and their associated risks without getting lost in the vast expanse of the Debt world.
When we think of interest rates, deposit rates come to mind. It leads us to think that higher the better. However, when it comes to debt markets both interest rate and the movement in interest rate is equally important. This is because bond prices fluctuate with change in interest rates.
To elaborate, let us say RBI increases rates, and then all the new bonds are issued at a higher rate. This influences prices of all existing bonds. To understand why, let us look at an example. Assume you purchased a bond at Rs. 100 giving 8% interest. Now interest rates in the market rise and new bonds are available at Rs. 100, which give 9% per annum interest. At this juncture if you go to the market to sell your bond you will get a price lower than Rs. 100 as other people would prefer bonds giving higher interest. So, you will have to lower your price to make your bond attractive to buyers. In short, rise in interest rate leads to fall in bond prices while fall in rate triggers a rise in price of existing bonds.
Furthermore, the impact of interest rate change is higher in case of long tenure bonds compared to those having a short tenure. To understand why, let us continue with the earlier example. Say the 8% bond that you hold will expire in one year. That means that a person buying a 9% bond will earn Rs. 1 more. Thus, to make your bond attractive you can sell it at Rs. 99. On the contrary, if your 8% bond was to mature in 10 years. Then over next 10 years your bond will earn Rs. 10 less than the 9% bond. Now the buyers will be ready to buy your bond only at Rs. 90.
This brings us to our second parameter that is duration. When we talk about portfolio duration of a debt scheme, we need to remember that longer the duration more the impact of change in interest rate on the scheme’s portfolio. This makes schemes having higher duration riskier than schemes with lower duration.
Certain schemes generate income from change in bond prices due to interest rate movement. Generally, portfolios of these schemes have higher duration to maximize returns when interest rates fall. The main risk in these funds is rates moving upwards.
Let us now move towards the third parameter, that is credit rating. Credit rating mainly indicates the ability of the bond issuer to pay back the loan. Higher the credit rating, greater the ability and vice versa. Hence, bonds having lower credit rating give higher interest. That higher interest is the bond issuer compensating you for taking higher risk.
To understand this better, let us take an everyday example. When you purchase vegetables, the vendor tends to charge higher price for fresh vegetables than the older stock as fresh vegetables have lower risk of spoilage. Thus, people buying older stock need an incentive in terms of lower price to compensate them for the risk. In bonds, issuers incentivize buyers to take higher risk by offering higher interest rate.
Some schemes generate income from interest payments made by invested bonds. The risk of default is the main risk in these funds. As investors, you need to check the credit rating of the invested bonds and decide whether you are comfortable with the risk.
By now, you must have got a better idea about what factors drive debt products. Keep these principles in mind while evaluating a bond fund and don’t let the word ‘Debt’ confuse you anymore.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.