How do debt funds generate returns?

What to do when falling interest rates leaving you with no fixed income choices and you are stuck with traditional schemes like Fixed Deposits? You can utilize this opportunity to invest in debt funds, which can help you to get an ideal mix of tax efficiency, safety, and returns. These funds offer varied solutions to your different investing needs across investment tenures and risk profiles. If you are not willing to invest in a highly volatile equity market, then debt funds are suitable for short term and medium term investment horizons.


What are Debt Funds?


Debt Funds are mutual funds that invest in different fixed income instruments such as Government Securities, Corporate Bonds, PSU Bonds, and Money Market instruments among others. Usually, these securities have a fixed rate of interest and a maturity date under which investors need to choose a tenure they want to be invested in. The debt funds are broadly categorized in five categories including Dynamic BondFunds, Income Funds, Liquid Funds, GiltFunds, Short-Term and Ultra Short-TermDebt Funds, Credit Opportunities Funds, and fixed maturity plans(FMPs). In simple terms, a debt fund purchases bonds or securities and provides the interest earned from them to its investors.


How Debt Funds generate returns?


For an investor, buying a debt instrument is to earn interest income and capital appreciation. Falling interest rate regime encourages to invest in long-term securities, while a risein interest rate boosts an investor’s confidece in short-term securities. The interest that an investor earnson these debt securities is pre-fixed and comes with a duration after which the debt security will mature. The returns on debts funds vary for different types of securities, making them safer avenues for conservative investors. There are two important bond concepts you should understand to get a quantitative understanding of the risks and returns associated with debt funds:


Yield to Maturity (YTM): For a debt fund, it is the return which the fund will get by holding the securities in its portfolio to maturity. 


Modified Duration: It is the measurement of how many years, it takes for the price of a bond to be repaid by its internal cash flows of the bond.


So, if we combine these two concepts, we can come up with a formula to calculative indicativereturns based on certain assumptions. For example, if you invest INR 100,000 in a debt fund portfolio with a Yield to Maturity of 8% and Modified Duration of 10 years. Let’s assume that your investment horizon is 3 years. You assume that in the next 3 years, interest rates or yields will decline by 2%. The expected return will be:-

Return = Investment* (1+YTM %) ^ Holding Period + Investment *Modified Duration* Yield

Return = INR 100,000* (1+8%) ^3 + 100,000*10*2% = INR 145, 971


While this just a rough estimation of returns, you need to deduct the expense ratio from the gross returns to get actual net returns. Also, the value of net returns will depend on YTM, andmodified duration as these elements may change over time.

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