Debt 101: Understanding Debt

Debt mutual funds receive little to no attention from retail investors.

The most important reason being the difference in returns that debt mutual funds and equity mutual funds generate.

Over the long term, equity has always outperformed debt. Moreover, there is a fundamental reason why this trend will continue probably forever.

But should returns be everything? It should be the end goal, yes. But if you can boost your portfolio returns by the use of debt investments… why not?

Learn how Alpha SIP leverages asset allocation between debt and equity to boost your portfolio returns

Another reason is debt, as an asset class, is a bit tricky to be understood by an average investor.

This blog series is an attempt to help you understand everything about debt and debt mutual funds.

By the end of this blog series, you will be able to understand debt-related terminology like duration, you will be able to understand why equity outperforms debt, why debt is safer than equity among other things. If you read this entire blog series, you will be able to identify if and which debt mutual funds are suitable for you.

So, let’s go!

What is debt

debt mutual funds basics

Equity is easy to understand – everyone knows it refers to ownership.

Looking for the best equity mutual funds? Here you go!

Debt, on the other hand, simply told, is a loan. Debt, bond, debentures all these terms imply that the investor is lending money or giving a loan to an entity.

Now, the loan could be for various reasons. The entity or organization would require loan as capital for a new project or for even for their day-to-day operations!

And like all loans do, the borrower pays interest to the lender.

So, debt is a loan that you lend to an entity and the entity pays you an interest on the loan (principal) it has borrowed from you.

How does the price of debt change

Debt, at the face of it, is pretty straightforward.

It is a loan (principal) that you lend to an entity for a certain tenure. During that tenure, the entity makes payments (interest payments) to you at a certain rate of interest. And at the end of the tenure when all the payments have been made, the principal is returned to you.

However, make these loans tradeable and you have made debt complicated.

Let’s say you loaned an entity Rs. 1,000. The entity promises to pay 8% interest per annum on a yearly basis for 20 years. So, you will get Rs. 80 per year for 20 years. And at the end of 20 years, you will get the last interest payment – Rs. 80 – and the principal – Rs. 1,000 – back.

Let’s add a layer of complexity.

The same entity now, for some reason that we will discuss later, has started offering an interest rate of 9%. Note that you had lent money under a different interest rate agreement which doesn’t change. But the new debt the entity is issuing is at a higher interest rate.

Do you think it would be better to switch to the new loan with higher interest rate?

Yes! But how?

Well, step number 1 would be to sell the first bond. But do you think someone would buy it?

Now, a new investor would have two choices – buying your old bond which pays interest at 8% or buying the new bond of the entity which pays interest at 9%. Only an insane person would want to buy the old bond if both are available at the same price.

But you cannot live with the old bond for the next 20 years. It’s just not worth it.

So, you make an offer. You announce that you will sell the old bond at Rs. 950 instead of Rs. 1,000 – the original price.

That might get someone interested. And after a negotiation, you may be able to sell the bond at Rs. 900.

Selling a bond (that originally paid Rs. 1,000 for) at Rs. 900 means taking a discount.

Let’s say the same entity now, for some reason again, has started offering an interest rate of 7%.

Now, a new investor, can buy either the new bond which pays 7% or search for a bond owner who is ready to sell one of the older bonds which pay 8% or 9%.

Well, if he intends to make money, he should buy the 8% bond if not the 9% bond. But how?

If you hold a 9% bond, there is no way you are going to sell him it at Rs. 1,000 if the 7% bond is also being offered by the company at Rs. 1,000.

But you see this to be a good money-making opportunity. You announce that you will sell the 9% bond at Rs. 1,150 instead of Rs. 1,000 – the original price.

That might get someone interested. And after a negotiation, you sell the bond at Rs. 1,100.

Selling a bond (that originally paid Rs. 1,000 for) at Rs. 1,100 means earning a premium.

This basically tells us that bond prices and interest rates are inversely proportional.

One more take away is – bonds are nothing but fixed deposits like instruments that can be traded.

What are the risks of debt

Debt is primarily exposed to the following risks –

  1. Interest Rate Risk
  2. Credit Risk

Interest rate refers to the policy rate (AKA repo rate) set by the RBI.

Think of money as reservoir water. Think of policy rates as dam. You, me and other residents of India are villagers who require water to live.

The RBI is the dam operator who decides how much water to supply to us so that we don’t have neither too little nor too much of water.

Without going into other intricacies, the RBI changes the policy rates and decides how much money should be in the economy.

The RBI may increase the policy rates or try to close the dam if it feels that the villagers have more than sufficient water and vice versa.

This very policy rate decides all other rates of lending in the country – fixed deposits, bonds, debt mutual funds, home loans, car loans, personal loans etc.

If the policy rate increases, the interest rates on the loans mentioned also increase and vice versa.

When the second bond of 7% was issued in our example, maybe the RBI reduced the policy rate which would have prompted the entity to issue loans at a lower rate – 7% instead of 8%.

When the third bond of 9% was issued in the same example, maybe the RBI increased the policy rate which would have prompted the entity to issue loans at a higher rate – 9% instead of 7%.

However, this is not the only reason why the interest rates on the bonds could have changed.

What if the credit quality of the entity was affected?

What is credit quality?

debt mutual funds

Credit quality refers to the trustworthiness of the borrowing entry. The confidence that the borrowing entity will make the interest payments on time and not default.

A number of firms specialize in assigning credit ratings to borrowing entities. Some global names are S&P (Standard’s and Poor’s), Fitch and Moody. Some local names are ICRA, CARE etc.

They evaluate companies based on their financials, management etc and assign a rating that makes things simple for prospective lenders like you.

Think of your credit score. It tells banks and NBFC’s how trustworthy you are based on your past records of paying back of loans.

If you have an impeccable record of paying back of loans, you will be offered future loans at a very low interest rates. If your record of paying back of loans is not up to the mark, you will be offered loans at a high interest rate since the bank/NBFC wants higher reward for higher risk.

Similarly, since borrowers with high credit quality will have more takers the borrowers will be able to sell off their bonds at a relatively low interest rate.

The low credit quality borrowers, on the other hand, will have a hard time selling off their bonds. They need to lure investors so that they will buy their bonds. So, they lure the investors by offering relatively higher interest rate on the bonds.

debt mutual funds basics

In the example a couple of sections ago, it is not necessary that interest rates forced the borrowing entity to borrow at different rates as we suspected in the last section.

When the borrowing interest rate was 8% in the first case, the entity had a credit rating, let’s say, AA.

The next time, it could have issued debt at 9% because its credit rating was downgraded by 1: new credit rating A. This could have been because a crack in the financials was discovered, the management had issues or the credit rating agency discovered something negative about the borrowing entity. Now, with the ongoing issues, it became difficult to find investors who would buy its debt. So, to lure investors, it increased the interest rate to 9%.

We have seen a couple of popular examples of downgrades/prospects of downgrades in IL&FS and Essel Group (Zee) recently. These entities have lost their credibility in the eyes of most investors and will have to work hard to earn it back.

When the next time it issued debt at 7%, it could have happened that the credit rating rose by 2: new credit rating AAA. This is because now the entity became more creditworthy and had more debt takers. This allowed it to leverage the increased demand.

It need not be just one of the two factors – policy rate or credit quality – that determines how the debt market is going to be affected. In most cases, it is a mixture of these two.

By now, we have made some serious progress.

We know –

  1. Bonds are akin to tradeable fixed deposits
  2. The prices of bonds go up if the interest rates go down and vice versa
  3. Higher the credit quality of the borrower, lower the interest rate it offers and vice versa

Let’s understand two more features of bonds before we move on to selecting the best debt mutual fund at for particular scenarios.

Here’s how you select the best equity mutual funds: Finpeg CRAFT Framework

Some debt terminology

Maturity of a Bond

Most readers would be familiar with this easy, bond term.

Maturity of a bond is the time after which the principal comes back to you.

If you invest in a 5-year fixed deposit, the maturity of the fixed deposit is 5 years.

If you invest in a bond which pays 8% interest annually for 10 years, the maturity of the bond will be 10 years.

Duration of a Bond

Duration is probably the trickiest concept in the topic of fixed income instruments.

The confusion is greater since maturity and duration have very similar meanings in the English language.

But duration is not the same as maturity.

Duration is interpreted/estimated in two ways –

  1. The time in years it takes for the sum of the bond’s cashflows to become equal to the bond price
  2. The sensitivity of a bond to 1% change in interest rate

The greater the duration of a bond, the riskier it is to invest in it. Let’s see why…

If the duration is great, then the time in years it takes for the sum of bond’s cashflows to become equal to the bond price is long. What if the borrowing entity defaults before this happens?

Additionally, a 1% fluctuation in the interest rates, will affect (increase or decrease) a bond’s price with greater duration more than a bond with relatively lower duration. This increases the volatility of your bond investment.

So, we are ideally looking for a low duration bond since the returns of the bond are less affected by interest rate fluctuations.

But should you be investing in a low/short duration bond always?

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