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Posted on 10/1/2018 6:30:00 PM

Many investors are unfamiliar as to how debt funds generate returns. Corporates need to raise debt to finance various requirements such as working capital and capital expenditure. These needs can be met by borrowing from a bank through loan or raising resources from debt capital market. Debt securities such as commercial papers (CPs), non-convertible debentures (NCDs) and bonds are issued by corporates to raise resources from debt capital market.

The government too raises resources from debt capital market by issuing instruments referred to as treasury bills or government securities. There are two components of debt fund returns – price appreciation and rate of interest on the investment (commonly referred to as coupon, payable on the principal amount). The price appreciation in debt securities is sensitive to movement in interest rate. When interest rates increase, the prices of debt securities decrease and vice versa. Any debt investment is exposed to various risks, prominent ones being credit risk and interest rate risk. Credit risk is the risk of a decline in credit worthiness of the borrower or his default and interest rate risk is the change in prices of the debt security on account of the increase in interest-rates. With this in mind, here are the factors an investor must consider prior to investing in a debt fund. The relationship between rate of interest on principal amount and the market price of the debt security is captured by a metric called the yield. A higher yielding investment has a potential to generate more return, but let’s not forget it is exposed to higher risk.

Many investors get attracted to a fund offering a higher yield. It should be noted that yield is not the all-encompassing statistic for debt funds. Judging the expected return of a credit fund from its yield may be misleading as there may be a significant amount of credit risk involved. One should evaluate if the fund is taking higher risk to show a higher yield. Let me explain this by an analogy. Most of us enjoy driving on the expressway.

Just because the car is able to run at a speed of 200 kmph, does not mean that one has to drive at that speed. It is common knowledge that the probability of accidents increases substantially if a vehicle is being driven at higher speed. Same is the case with debt investments. In order to generate higher returns on investments, investors may invest in riskier assets (a phenomenon referred to as “yield chasing"), only to find that their investments have been jeopardized. In many cases, the incremental addition to portfolio returns is insignificant when compared to incremental risk investors are exposed to.

Looking at it differently, a lower yielding investment could offer better risk-adjusted returns. As the great Warren Buffet says, the first rule of investing is don’t lose money. There is indeed a case, where 0.5% lesser return can actually be more on a risk-adjusted basis. Investors must try to understand how the fund has derived its returns. It is possible that the fund may have increased its investments in lower credit quality papers, offering higher returns. Rating composition of the fund (as depicted in the fund’s fact sheet) could be a fair indicator of its credit quality. But, one must also understand that credit rating is a matter of opinion. As is the case with opinions, there can be variation in ratings issued by different rating agencies.

In some cases, investors may be compromising on the security available for the debt instruments in return for the increase yield available. In many cases, the security available enhances the credit profile of the transaction.

Investors must also find out if there are significant concentrations in the fund-issuer, group or sector level. The way to avoid adverse impact on the fund is to ensure adequate diversification.

To summarize, a well-run debt fund would have investments diversified assets across sectors and issuers, focus will be on building a quality portfolio, offering better risk adjusted returns.

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