The income fund I invested in returned only 5% last year. I would be better off investing in the fixed deposit of my neighborhood bank. I can get 9.5% for a one-year deposit. This used to be a familiar argument till some time back. Then came the FMPs – or the fixed maturity plans from mutual funds. These FMPs looked like Godsend for the mutual fund sellers. Why? Based on the interest rate scenario at the time of launch, the returns to the investor can be easily predicted. That gives a lot of comfort to the conservative predictability-loving fixed income investor. Let us explain this and that should start with an understanding of how fixed income instruments (and the fixed income funds) work.

Fixed income mutual funds, popularly known as income funds or debt funds, invest in debt securities issued by either the Government or companies, including banks. These debt securities are also known as debentures or bonds if the term is longer than one year, and treasury bills, commercial papers or certificates of deposit if the term is less than one year. The debt securities are obligations on part of the issuer to pay the principal and interest thereon as per an agreed time schedule.

This concept of debt securities is quite familiar to most investors, as majority of the Indians have invested in these investment options, either through bank deposits, or small saving schemes, etc. All the fixed deposits or other such fixed income investments have a face value on which interest is calculated. Investors are mostly concerned with face value, interest rate, frequency of interest payment, the time period, safety of the investment option and maturity value. Most often these investments are held till maturity.

As can be seen, the future earnings from the debenture will change in line with the interest rates in the market. If the market rates go up, the future earnings would go up and vice versa. However, the market price of the security would have gone down (or up) if the market interest rates have gone up (or down).

In other words, for an existing investor, the value of the holdings would go down immediately when the market interest rates move up, but the future earnings would be higher and vice versa. Thus, it actually does not make sense to look at the past performance of a debt fund in isolation while taking an investment decision. The past performance of the fund has to be seen in light of various things like the quality of the portfolio (credit quality of debt securities in the portfolio), maturity profile of the portfolio, liquidity of the underlying debt securities and the relative performance of the fund with respect to a relevant benchmark.

Most often, we are faced with options to invest either in a fixed deposit or a debt fund. While the potential future earning from a fixed deposit (the interest rate) is known to an investor, the same from a debt fund is unknown. In such a scenario, one resorts to looking at the past performance of a debt fund – and that is where one is comparing future returns (from fixed deposit) with the past returns (from a debt fund). As explained earlier, if the future returns from debt funds get adjusted whenever there is a change in market interest rates (the same does not happen to one’s existing fixed deposits), and the said adjustment happens through change in market price of the security, it is unfair to compare future returns of a fixed deposit with past performance of a debt fund. What one needs to compare is the easily available number called YTM (yield-to-maturity) of the debt fund portfolio with the interest rate offered by the fixed deposits. However, while looking at investment in debt funds, one need to keep a certain time horizon in mind as the YTM or the interest accrual happens at an incremental rate, the adjustment in value of securities (and hence the fund’s NAV) may be much bigger than the accrual for many days. A holding period in line with the maturity of the portfolio may offer returns close to the portfolio YTM less the expenses.

- Amit Trivedi

The author works with a leading mutual fund company. The views expressed are his personal views.

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