Debt funds too have mark-to-market risk. Photo: iStock
Mutual fund investments are subject to market risks, goes the statutory warning. But what is the risk the disclaimer refers to? In part, it is the daily swings in your MF’s net asset value or NAV. This daily change in the value of your scheme—be it equity or debt—is referred to as marking to market.
This is not easy to understand for debt funds because bonds are equated with regular payouts, return of principal and safety. But debt funds too have mark-to-market risk. Here is why bond prices and, hence, the value of your debt fund changes daily.
Why do bond prices fluctuate?
Bond prices are linked to their regular pre-determined interest payouts and their time to maturity. Every bond or money market security has a face value and an interest rate known as the coupon.
For example, a ₹1,000 face value bond A with an 8% annual coupon promises to pay the holder ₹80 and matures after five years. This bond pays ₹80 at the end of each year and returns the principal after the fifth year. You may wonder why the price of this bond should fluctuate, given that the interest rate, time and face value is fixed.
Let’s say, you want to buy this bond after two years have gone by. Which means you will hold it for only three years till it matures and not five; you will get only three payouts of ₹80 each, making your aggregate earning ₹240 instead of ₹400 (for five years). Will you be still willing to pay ₹1,000 per bond for that?
Now let’s assume there is another bond B with a face value of ₹1,000, with three years maturity at an annual interest rate of 9%.
Both bonds will mature in three years and pay you back ₹1,000, but bond B will give you an aggregate earning of ₹270. Will you be willing to pay the same price today for bond A and bond B? Ideally, a lower earning will mean you are willing to pay a lower price for bond A. Hence, the market price of bond A will be lower than ₹1,000. This is why bond prices are inversely linked to interest rates. If interest rates are rising, prices of existing bonds will fall and vice-versa.
Let’s say there are only these two bonds in the market and perfect pricing. You pay ₹970 for owning bond A, and your net earnings after three years would be ₹240+ ₹1,000 -₹970, or ₹270. If interest rates keep rising every day, the price of bond A will keep falling—taking it further away from ₹1,000. You may not like this and sell out after 5 days of price fall and a loss. But had you held on for three years, it would have matured, and you would have earned a net of ₹270.
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Similarly, in certain types of debt funds, bonds and money market securities are held till maturity (known as accrual). In general, if you hold a predominantly accrual-based fund for the relevant time, your return will be close to the aggregate portfolio yield (linked to aggregate interest rate of underlying bonds) and the daily mark-to-market impact will not matter.
But not all bond funds have accrual strategies. There are those which trade significant portions of the portfolio for capital gains which makes them riskier.