What are the strategies used in debt funds

Debt funds invest in fixed income instruments, such as bonds, commercial papers, certificates of deposit and treasury bills. These instruments are safer than equities, but are not completely free from risks. The main factors that impact the value of debt instruments are interest rates, exchange rates, inflation and policies of the central bank. Apart from these, a weakening of credit rating of the issuer is also a source of risk for non-government debt papers. Let us look at some of the strategies that debt fund managers adopt.

Buy and hold: It is also known as the passive debt management strategy, wherein the fund manager invests in high-yielding debt securities and aims at holding them till maturity. He encashes on the regular coupon payments and the returns thus generated are considered sufficient to reward the investors. However, the strategy holds good as long as the general interest level remains stable. Any increase in interest rates or yields results in a capital loss to the portfolio. This, in turn, negatively affects the NAV of the fund.

Duration management: It is an active debt management strategy and involves altering the average duration of bonds. Duration is a measure of the sensitivity of a debt instrument, say, bonds, to changes in interest rates. Generally, the longer the duration, the higher the sensitivity, and vice versa.

The fund manager alters the average duration of bonds according to his expectations of the future direction of interest rates. If the rate is expected to fall, the fund manager buys bonds with longer duration and sells those with shorter duration. This process continues until the fund’s average duration rises above the market average duration. This strategy is akin to the timing strategy that is followed in equity markets.

Credit selection: This strategy involves an investment in debt instruments in anticipation of the changes in their credit rating. Any increase (or likely rise) in the credit rating of a debt instrument will lead to a rise in its price and this, in turn, will enhance the returns. The fund manager analyses the credit quality of the debt instrument to implement this strategy. An active credit selection strategy would imply frequent trading as debt instruments are bought and sold regularly in anticipation of a change in the credit ratings.

Prepayment prediction: Some bonds allow the issuers the option of calling for redemption before maturity. Such call options impart a prepayment risk to the funds that are holding high-yielding debt. This is because the high-yielding bonds with call option can be called back by the issuer when the interest rates fall.

Under this strategy, the fund manager strives to hold bonds with a low prepayment risk or tries to predict the course of interest rates and determine the likelihood of the prepayment risk. The fund manager increases or decreases the exposure of high-yielding bonds after determining the extent of the prepayment possibilities.

The above investment strategies help fund managers strive for returns that beat the market. However, none of the above options safeguard the debt securities from the risks arising from the loss of purchasing power (due to inflation) and defaults.