Can debt funds give fixed returns?

B. Venkatesh

MY neighbour believes that debt mutual funds provide fixed returns. His argument is simple. Debt funds invest in government and corporate bonds, which carry fixed rate of interest.

Since mutual funds pass on the income earned from bonds to the unit-holders, their returns ought to be fixed as well. But, my neighbour's understanding is incorrect. Why ?

The fixed interest rate the funds earn on bonds is relevant only if these securities are held till their maturity. Funds, however, buy and sell bonds continually.

A fund, for instance, may think that 10-year bonds are over-valued at the current price and may, hence, sell the security. It may, on the other hand, perceive value and, therefore, buy the five-year bonds.

If a fund sells securities at a higher price than its acquisition cost, unit-holders get to share the profits based on the number of the units they hold. Likewise, if the fund sells securities at less than acquisition cost, unit-holders have to bear the losses.

The continual buying and selling of bonds means that debt funds generate returns to unit-holders in two ways: Interest-income on bonds held and profits/losses on bonds sold.

But, since funds frequently buy and sell bonds, profits/losses on such sale constitute a substantial proportion of the unit-holders' returns than interest earned. This may be the reason why funds value their units based on the net asset value (NAV). The NAV is nothing but the market value of the securities held by the fund divided by the number of units sold.

Suppose fund "X" has invested Rs 1,000 in government bonds and has sold 100 units, the NAV will then be Rs 10 (Rs 1,000 divided 100) per unit. If the market value of the securities in X's portfolio were to rise to Rs 1,200, the NAV will also rise to Rs 12 per unit.

The unit-holders are, thus, subject to the fluctuations of the market price of the bonds. And this means the unit-holders cannot earn fixed-rate of return from debt funds.