When Sam, the CEO of the company, analysed the cash flow position of the company, realised that his company allows a big chunk of money to sit idle in bank accounts. To optimise this situation, he decided to explore the potential of debt funds to deploy this idle cash into short-term fixed-income securities.
However, as Sam explored more the world of debt funds, he met a perplexing phenomenon: the returns from these investments were not consistently fixed despite being associated with fixed-income securities. This left him pondering: Why don’t debt funds provide fixed returns when they were investing in supposedly fixed-income assets?
If you find yourself reading this blog post, there are chances of you sharing Sam’s concerns. Worry no more, as we have got you covered. In this blog, we will end your dilemma of varying returns of debt funds and help you make informed decisions before you invest business money.
So let’s dwell right into it.
The returns of every mutual funds investment depend on the NAV of that fund. This statement holds true for both equity and debt funds. It might be surprising for Sam to know that the underlying debt instruments in a debt mutual fund also have a market value of their own.
Let’s break it down and make it simple:
Different Rates for Papers
Debt mutual funds invest in a number of securities of different types, ranging from bonds & certificates of deposits to money market instruments and more. Each of these securities comes from various sources like government bonds, bank certificates, or even bonds from different companies.
Now, here comes the complex part. Each of these sources (like a bank or a company) decides how much interest they will pay on their instruments. So, some of them may pay a higher interest rate, while others will pay a bit less. It means that every instrument in a particular debt fund has a different interest rate.
But it is not the end. These instruments also have different maturity dates. Just like fruits in a fruit basket that ripen at different times. Some financial instruments in the fund are due to return your money soon, while others will take more time. When one of these instruments matures, the fund manager gets the money back. Then, they take that money out and put it into a new instrument, like getting a fresh fruit to replace the one you just ate. As a bigger impact of these small changes, the interest collected from these various instruments increases the total amount of money in the fund, and that changes the value of your investment.
A debt fund is like a basket of different financial instruments with varying interest rates and maturity dates. As these instruments mature, the fund manager replaces them with new ones, affecting the fund’s overall value and debt fund returns.
The interest collected from these various instruments increases the total amount of money in the fund, just like picking ripe fruits and adding them to your basket. And as a result, the fund’s total value or the Net Asset Value (NAV) go up. Why is this important for you? You might be wondering. When the fund value increases because of the earned interests, your part of it also becomes more valuable, and that is how you make money. It is your return on investment.
To simplify, all the instruments in the fund have different interest rates, and because the fund keeps changing those instruments as they mature, it’s really hard to figure out exactly how much interest the fund has earned overall. So, it’s nearly impossible to predict in advance how much your investment will grow. The constantly shifting mix of instruments makes it challenging to calculate or guess the accurate amount of interest the fund has made.
Market Value of Papers:
The financial instruments held by a debt mutual fund, such as bonds and certificates of deposit, have their own market prices, similar to the stocks. These instruments are actively bought and sold in the financial markets. The NAV (Net Asset Value) of a debt fund reflects this market value.
You can consider NAV as a real-time snapshot of the total value of all the financial instruments in the fund. Just as stock prices change daily, the market prices of these bonds can also change. When bond prices go up, the NAV of the fund increases, making your investment more valuable, and when bond prices go down, the NAV drops, which can affect your investment’s value.
Bond prices are influenced by changes in interest rates. If the central bank lowers interest rates, new bonds issued will have lower interest rates because they reflect the current lower rates. As a result, the value of existing bonds changes. There are possibilities of price rise because more people want to buy them since they offer better interest rates than the newer ones.
Conversely, when interest rates rise, the new bonds offer higher rates which makes the existing bonds with lower rates less attractive, so their prices drop. Additionally, if a company’s credit rating improves, it can borrow money at lower interest rates. This improvement can lead to higher demand for its existing bonds, which were issued at higher rates due to the company’s previous, poorer credit rating. As a result, the prices of these existing bonds can also increase.
But it is not just interest rates; several other factors come into play, like liquidity and the balance between supply and demand. All of these factors influence bond prices, and because there are so many of them, it gets arduous to predict how bond prices will change. This unpredictability in bond prices, in turn, affects the NAV and ultimately the debt fund returns.
It is essential to note that this marking of instruments to their market value is a practice that applies to various types of funds, not just liquid funds.
Selling Off Papers:
The scheme-related documents of debt mutual funds always mention the yield-to-maturity of their current portfolio. It means that if the fund were to hold all the financial instruments in its portfolio until they matured, the return or yield would be a certain amount. However, funds aren’t obliged to keep these instruments until they mature. They can choose to sell some of them if they believe they can make money from the price appreciation. Additionally, as instruments mature, they make way for new ones in the portfolio. These changes affect the overall yield to maturity of the fund.
But even though we can’t predict exact returns, one thing to remember is that debt funds tend to be less volatile than equity funds. So, while debt fund returns may not be fixed, they are generally steadier and don’t experience the rapid ups and downs you often see in the stock market. They remain a popular choice for investors seeking stability in their investments.
Investment in Debt Funds Never Been Easier!
Planning to invest business money in mutual funds? That is the CEO mindset to take business to new heights. Instead of keeping the excess funds idle in the current account, fetching you 0% returns, debt mutual funds can help you win the investment game with the secret tools of security and stability.
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Disclaimer: Mutual funds Investment are subject to market risks. Read all scheme-related documents carefully.
The content of this blog is not intended to serve any professional advice or guidance, and Shootih takes no responsibility or liability in whatsoever manner for any investment decisions made by the readers of this blog or other blogs. Readers should seek independent professional advice before making any investment decision based on the information provided on this website.
