Active Debt MF > Passive Debt MF

Like in Equity, it’s a misconception amongst investors in Debt as well that because passive is cheaper the answer to all their requirements is Passive #investing, not really!

(Q1) Lets start with the very basics of how Debt Mutual Fund works?

(1.1) When you invest lets say Rs. 100 in a debt Mutual Fund Scheme, the fund manager allocates that 100 to multiple bonds. It’s like investing 100 rupees across FD’s of the government, corporate, NBFC’s, banks etc

(1.2) Here Rs. 13.34 of the 100 is invested in Government of India (GOI) Bond paying an interest of 7.38% & maturing on 20/06/2027, 4.79 is invested in Tata Power company paying an interest of 9.70% & maturing on 27/08/2023 & so on

(1.3) This scheme has 97 bonds it has invested in total & hence as an investor you get diversification across 97 bonds for your Rs. 100

(1.4) The returns earned from the 97 bonds minus the MF company’s fee to manage the scheme (TER) is the net return you make as an investor

(Q2) How does Debt MF make returns anyway?

Debt MF’s make returns in 2 ways,

(2.1) Coupon - Coupon is the interest that your Bond keeps paying out at intervals. So if I have invested in 97 bonds, 97 bonds will be paying me some coupons/interest regularly which is pre defined. Like 7.38% that the GOI bond was paying in the above example.

(2.2) Capital Appreciation - Like Equity, bonds also trade. So if you have bought the above GOI bond at 100, it can become 105 or 95 before maturity where you can buy/sell. If it becomes 95, you can keep holding till maturity because at maturity you are going to receive your principal 100 (Like in an FD) & hence the 5 rupee is a notional loss & if it becomes 105, you can sell it & make 5 rupees of capital gains.

So you can make returns in Debt MF’s by Coupons + Capital Appreciation.

(Q3) So when do we get capital gains in Debt MF’s?

(3.1) Coupons are fixed & you will keep making them & it’s predetermined till the time the company does not default

(3.2) Capital Gains arise because of 2 risks,

(a) Credit Risk - Lets say you invested in a AA rated bond at 100. If the credit rating of the bond upgrades to AAA, the bond will start trading at 105 because the risk on the bond has gone down (Credit rating up) but you are still making the higher coupons that it paid when it was AA rated

(b) Interest rate risk - If you have invested in a bond at 8% coupon & 6 months later, the market interest rate falls & the new bond of the same company is now issued at 7%, the value of your old bond will increase to 105 as you will still keep receiving 8% coupon where as the market rate for new bonds is now 7%

So, you make capital gains & hence more returns than the coupons when either credit rating betters or over all interest rates fall

(Q4) Explain my total returns in a Debt MF with an example

(4.1) If everything else kept constant, looking at the current market price of all the 97 bonds & the coupons that the fund is supposed to receive, you can expect making 8.26% return (Yield to Maturity (YTM)) if you hold the investment for atleast 3.82 years (Average Maturity)

(4.2) There is no probability of making capital gains from Credit Rating upgrade as the portfolio is already AAA & cant become any better than that

(4.3) But yes, you can make capital gains if the interest rates in the market fall. So for every 1% fall in rates in the market, you make capital gains equal to the funds modified duration. 

-        So in our example, for every 1% fall in rate, you make 2.22% capital gains over & above the 8.26%.

-        If market rates fall by 2%, you will make 2% * 2.22% = 4.44% capital gains over YTM.

-        If the funds modified duration is 5 & rates fall by 1%, the capital gains will be 5% over the YTM

-        Higher the fall in rates, higher is the capital gains. Higher the Modified duration, higher is the capital gains potential.

(4.4) The expense / TER in this scheme is 0.77% & hence if the rate falls by 1%, the net return you make is 8.26% + 2.22% - 0.77% = 9.71% vs most passive funds trading at ~7.5%

(Q5) Difference between Active & Passive Debt Funds

(5.1) Active Funds are,

-        More expensive vs Passive

-        Don’t have a fixed maturity date & hence predictability of returns cant be like an FD. You can guestimate like we did 9.71% in the above example

-        You can make capital gains / losses 

(5.2) Passive Debt Mutual Funds i.e. Target Maturity Funds,

- Are the best FD replacement products

- Lower Cost

- They have a fixed maturity date & hence a more predictable return outcome. But cant make capital gains at maturity i.e. Bharat Bonds.

(Q6) Why is active better than passive right now?

(6.1) If you are looking for an FD replacement where you know when the maturity is & how much will you get, passive is for you irrespective of the market situation & currently even better to lock yourself in at a higher rate.

(6.2) If you are looking for higher risk adjusted returns, active is brilliant right now with a 3 years view,

-        Interest rates have almost topped out, may be 1 more 25 bps rate hike & we are done & hence we are looking at the next year for rates to come down & hence capital gains like we have understood earlier. 

-        Active funds can also take credit risk & hence offer higher YTM which passive does not. This is arguable if you want to take it or not is a separate story because there are active funds, which don’t take credit risk as well.

Higher the modified duration of the fund, higher the returns you can expect. The below situation can be guesstimated assuming rates fall by 1% next year. vs the below, the average passive funds are at ~7.5%

The objective of the thread is not to pitch active or passive but to highlight how both play a very different role at different times for different requirements or different investors & hence will always coexist. 

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Signing Off,

Kirtan Shah

Founder & CEO

Credence Wealth Advisors