Unlike equities, bond investments do not, generally, suffer from the “catching a falling knife” metaphor.
Investors in debt funds of any flavor have had a tough time over the last few days.
RBI’s actions to constrain money market liquidity, in its attempt to arrest the fall in the value of the rupee in the foreign exchange markets, has led to a blood bath in the bond and money markets with yields rising sharply (equivalent to prices falling).
Price movements have been large enough to ensure that even liquid funds could not ignore market prices in their valuations. Liquid fund net asset values are generally expected to grow by small amounts every day (by ignoring actual price changes). However, that is true only if actual price movements in the market are small. In case of large price movements (generally greater than 0.1% on a portfolio basis) actual price movements have to be factored in.
The market had hardly recovered from the initial RBI move announced late on the night on July 15, that we had some follow up measures on July 23, which exacerbated an already bad situation.
Consequently even liquid funds have generated negative day on day returns at least on two occasions within the last 10 days (as on July 25, 2013).
These developments have led to apprehensions in the minds of advisors and investors, several of them unfounded.
So, given the experience of the past few days, how should advisors and investors evaluate fixed income or debt mutual fund investments.
It is no easy task, but some of the pointers below may enable you make a more informed decision
1. Appreciate the market linked nature of returns
Returns from debt mutual funds come from two sources:
- the regular coupon accruals; and
- the gain or loss that arises due to fluctuation in market prices
Unless there are credit defaults, the coupon accrues regularly every day, usually at a fixed rate – this provides the regular daily return to investors in the fund as long as market prices do not change.
The situation becomes complicated however, as market prices are rarely constant. When prices go up, the return gets enhanced, and when they go down they take away from the regular accruals. When the price fall is large, the regular coupon can be completely wiped out by the extent of the price fall.
To get a view of the relative weightages of the two components in the total return, let’s consider a single security portfolio which has a coupon rate of 10% per annum. In such a case, the daily coupon accrual per Rs. 100 of investment can be calculated as:
Daily Coupon Accrual = 0.10 x 100/365 = 0.0274
In other words the daily coupon accruals add a little less than 3 paise per Rs 100 of investment. This corresponds to a return of 10% per annum.
In contrast, price changes on a day can sometimes be as large as 20 to 30 paise per Rs 100 in case of very short term securities and as much as Rs 2.00 to Rs 3.00 in case of medium to long term securities.
When prices rise, they add to that 3 paise of coupon accruals. When they fall they take away from those accruals.
In effect, the returns are extremely sensitive to price changes in the market place.
This is what makes the return from these products attractive at times and unattractive at other times.
In the case of liquid funds which generally invest in securities maturing in 60 days or less, prices changes of upto 10 paise (approx.) are allowed to be ignored. Without this rule, returns from liquid funds would also suffer from volatility and the whole purpose of using liquid fund as a stable short term investment would be defeated.
However, when price changes are more than 10 paise, funds have no choice but to take on record these price changes and value the underlying securities accordingly. This is done to ensure that the valuation of securities in the portfolio does not deviate too much from the true market value. This is important since, if valuations are not close to market value, the fund returns would suffer volatility if and when the manager actually sells the security in the market.
The negative returns witnessed in liquid funds on a couple of occasions in the past few days was precisely for this reason (of valuing securities at their correct market prices). Prices fell by more than 10 paise and funds were forced to take on the actual market prices to value their portfolios.
The second part of this article will follow soon...
Dheeraj Singh was the Head, Fixed Income at IL&FS Mutual Fund before it was taken over by UTI Mutual Fund. Prior to this, he was heading the fixed income desk at Sundaram BNP Paribas Mutual Fund (now Sundaram Mutual Fund).
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.