The answer lies in the way debt funds are managed and the nature of their instruments. Debt fund returns depend on the rise and fall of the NAV. It may come as a surprise to you that debt instruments held in a debt fund are also traded and hence, have a market value.
Bond prices react to changes in interest rate. If the RBI reduces interest rates, then new bonds and other fixed income instruments will offer lower rates, and the prices of existing bonds will rise. This will cause a rise in the NAV of debt funds. The reverse happens on a rise in interest rate.
Fund managers could also sell off some of the bonds held in the portfolio to take advantage of price appreciation. The profit booked by the fund manager will boost the NAV or the return of the mutual fund. Thus, just as equity mutual funds’ returns depend on the market value of the shares held, return of a debt fund also depends upon the market value of the bonds. In market parlance, valuing instruments as per the market price for NAV calculation is called ‘marking to market’.
The extent to which the return depends on market price varies with the type of securities held in the fund. Shorter duration instruments will see a lower impact of interest rate changes than longer duration ones. Hence, long-term debt funds such as income funds and gilt funds may be subject to a slightly higher level of fluctuation than short-term funds. In fact, liquid funds by their very nature provide stable returns as they are exempt from ‘mark to market’ requirement. This is why these funds are positioned for ‘capital protection’ and stable returns.
Debt fund return comes from two sources—the interest rate component and the gain (or loss) on the value of the instrument. It is the interest rate component which yields stability to a debt portfolio. This is why debt funds are far less volatile than equity funds, even though their returns can’t be predicted. Unpredictability of returns is not something to be afraid of, as long as one understands where the risk comes from. He can simply choose to invest in a fund that suits his risk profile.