Thus, the best performing debt funds have to make smart and well-researched interest rate and credit calls to manage risk and deliver outstanding returns. A higher exposure to lower-rated bonds may push up coupon income but also increases credit risk. On the credit side, holding AAA or AA+ debt ensures safety of principal, but is likely to keep yields to the minimum. In contrast, funds that invest mainly in short-term securities like money market debt or treasury bills have stable NAVs, but do not benefit from capital gains. Funds with higher exposure to long term debt can make strong capital gains when rates are falling, but could generate massive losses when rates are going up. Strategies to Manage Returns Debt funds manage returns by varying the maturity profile or credit rating of their bond portfolios.That is because bonds with a lower credit rating, which are more likely to default, have to pay higher coupon rates as compared to bonds with a better rating. Such funds can increase yields by holding lower rated bonds. They earn mainly through interest payments. In market jargon, we say that funds with higher duration carry a higher mark-to-market (MTM) or interest rate risk.ĭebt funds that are mainly invested in short term bonds show limited capital gains and losses. So funds that hold more long term bonds are more likely to make capital gains or losses. In contrast, when market yields rise, funds with higher average maturity see a steeper decline in valuation. This means that funds with higher average maturity show a higher increase in net asset values. When market yields fall, prices of long-term bonds increase more than prices of short-term bonds. Capital Gains and Interest Earnings: Capital gains depend on the average maturity of the bonds held by fund.How much a debt fund earns through interest and how much through capital gains depends on the type of bonds held by it. The capital gain/loss component is also called the mark-to-market (MTM) return. When market yields fall, bond prices increase, and the value of the fund goes up. When market yields go up, bond prices decline and the value of the fund declines. Second, when interest rates change, bond prices move in the opposite direction, resulting in capital gains or losses on the fund portfolio. First, interest payments from its bond holdings generates coupon or accrual income. Sources of Returns: A debt fund earns in two ways.
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