In a debt mutual fund, you buy units at a certain net asset value (NAV) or price and sell it for a higher price in the future. You make the difference after paying taxes on the gains.

The money you invest is used by the mutual fund to buy a mix of government or corporate bonds that pay regular interest. Governments borrow for various social initiatives like infrastructure, defense, health schemes etc. when they haven’t collected enough money through taxes. Companies borrow for things like new factories or working capital (pay vendors now while waiting for customers to pay later).

The value of a debt mutual fund is the sum total of the value of all the bonds it holds. Since bond prices change daily, so does the value of the fund. Thus, the mutual fund portfolio has a daily value based on that day’s bond prices of the companies and government it holds.

How are bonds priced

When a bond is issued to investors, it comes with a fixed interest rate and the tenure or duration of the bond (the length of the loan). The interest rate offered depends on how risky the borrower is deemed to be by the bond market. Governments are usually considered lower risk, large companies are slightly higher risk and small companies higher than that. Higher the risk, higher the interest rate offered by the borrower to ensure they actually get the money they need from investors. Once the principal is repaid the bond “matures” and goes out of existence.

Investors use something called a discounted cash flow method to value and price bonds on a daily basis. A few concepts underpin this way of pricing a bond:

  • A payment today is worth than an uncertain payment in the future (so interest payments closer to today are more valuable than those far out in the future)
  • The Reserve Bank of India (RBI) controls the prevailing interest rate and it going up or down affects the bond the other way i.e. interest rate down = bond price up (you got more money by investing in the bond at a higher rate before the rate went down)
  • If a company is likely to default on a bond payment, those bonds should be worthless (since you’re unlikely to get your money back)

The bonds are traded in a “bond market” and investors buy and sell bonds from each other as they see fit. Or they just hold the bond until all the interest and principal payments are made, and the bond matures.

Daily Net Asset Value (NAV) calculation

The mutual fund company constantly values its portfolio based on the existing bond prices. Any cash in the bank is added and payables to others are subtracted to determine the asset value of the fund. A daily estimation of the expenses of running the fund is reduced from the asset value. This total asset value is divided by the number of units issued so far, resulting in that day’s per unit NAV.

Why use debt mutual funds instead of bank fixed deposits (FDs)

Because debt mutual funds can aggregate a large amount of money from many thousand investors, they can command a better interest rate than you and me trying to lend money to our bank in the form an FD. Also, debt funds lend directly to borrowers and those higher lending rates are transmitted to investors like you and me in the form of higher NAVs.

Finally, debt mutual funds have a tax advantage called indexation. If you hold them for at least three years and then sell, you can adjust the purchase price upwards by an inflation index published by the Income Tax Department. This reduces the gains, and you pay a tax of 20% on the indexed gains. This usually works out to be much lower than paying a slab rate of tax on bank fixed deposit or savings accounts. (What is indexation?)