Not all debt funds are the same. One basic way to distinguish between the different types of schemes and the risks associated with them is to identify the primary sources of their return. There are two sources of returns for debt funds. One is from the coupon or interest income that the fund earns on the securities held, and the other is the returns from the gain in the value of the securities. Together they constitute the total return of a debt fund.
The interest income forms a part of the returns of all portfolios that hold debt securities. The interest income is known at the time of making the investment and are received periodically or on maturity along with the principal. The coupon on a debt instrument depends on its tenor and credit quality. Bonds with longer tenors, typically, have higher coupons. Similarly, bonds with lower credit ratings, which imply higher default risk, have to offer a higher coupon rate to attract investors.
The second component of returns is from an increase in the value of the securities held. This gain in value will add to the coupon income and push up the net asset value (NAV) and returns of the scheme. The flip side to this is that there may be a decline in value and this will eat into the interest income and sometimes even take the returns to the negative territory. The gains or loss in the value of the securities is driven by changes in interest rates in the market. An increase in interest rates makes the existing securities that are paying lower coupons less valuable and their price goes down. The reverse happens when interest rates go down. Changes in the value of the securities makes the NAV and returns more volatile. The impact of interest rate movements on price is more on bonds with longer tenors.
Funds select the type of debt instruments to invest in depending on the investment objective. Funds that aim to provide stable NAVs and steady returns for investors focus on earning coupon income and avoid the risk of volatility by investing only in very short-term debt instruments. The returns from such funds may be low. Such funds include overnight and liquid funds.
Funds may try to increase the coupon or interest income earned by investing in bonds with lower credit rating. But the prospect of higher interest income comes with a greater risk of default. A change in the quality of the debt instrument will lead to an appreciation or depreciation in its value. In case of a deterioration in the quality of the instrument, its value will fall, leading to a fall in the NAV and vice-versa. In case of a default, the fund may neither receive the coupon payments nor the principal, leading to a loss for the investor. The extent of credit risk in a fund can be evaluated from the credit rating profile of the portfolio. Another way for investors to reduce the impact of a default, if any, on the NAV is to look for well-diversified debt portfolios where the exposure to each security is not very high.
Funds that target higher total return invest in longer-term debt securities to gain more from any appreciation in value, along with the regular coupon income. The returns from such funds are likely to be volatile since the NAV may move up and down with changes in the value of the securities. They are better suited for long-term investing.