How debt mutual funds work

A debt mutual fund purchases bonds and passes on the interest earned
from them to its investors. Here's a primer

Debt funds are a type of mutual fund that generate returns from their investors'
money by investing in bonds or deposits of various kinds. These terms basically
mean that they lend money and earn interest on the money they have lent. This
interest that they earn forms the basis for the returns that they generate for
investors.
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A bond is like a certificate of deposit that is issued by the borrower to the lender.
Even individual investors do something similar when they do something as simple as
make a fixed deposit in a bank. When you make an FD with a bank, you are basically
lending money to the bank. You can also buy bonds, for example the tax-rebate
bonds issued by various companies like REC and HUDCO.
This is exactly what debt funds do, except for a few differences. One, they are able to
invest in many types of bonds that are not available to individuals. For example, the
Government of India issues bonds. It is in fact, by far the largest borrower (and thus
bond-issuer) in the country. Individuals cannot buy government bonds. Bonds are
also issued by many large and medium sized businesses in the country. Mutual funds
also invest in these.
A simple way of understanding debt funds is to think of them simply as a way of
passing through the interest income that they receive from the bonds they invest in.
There are a couple of further complexities to this.
One, unlike the FDs that individuals invest in, mutual funds invest in bonds that are
tradable, just like shares are tradable. The way there's a stock market where shares
are traded, there's also a debt market where bonds of various types are traded.
Two, on this debt market, the prices of different bonds can rise or fall, just like they
do on the stock markets. If a mutual fund buys a bond and its price subsequently
rises, then it can make additional money over and above what it would have made

out of the interest income alone. This would result in higher return for investors.
Obviously, the opposite is also true.
But why would bond prices rise or fall? There can be a number of reasons. The major
one is a change in interest rates, or even the expectation of such a change. Suppose
there's a bond that pays out interest at a rate of 9 per cent a year. Then, the interest
rates in the economy fall and newer bonds start getting issued at 8 per cent.
Obviously, the old bond should now be worth more than earlier. After all, a given
amount of money invested in it can earn more money. Its price would now rise.
Mutual funds that hold it would find their holdings worth more and they could make
additional profits by selling this bond. Again, obviously, the reverse could happen
when interest rates rise. Despite the expectation of safety, such a situation could
actually result in some losses for a bond fund

Debt Fund vs Fixed Deposit

Debt Funds are becoming an increasingly widespread rival to the
hallowed FD. Here are their pros and cons vis--vis bank deposits

The bank deposit has been the instrument of choice of generations of low risk
investors. However it is becoming harder and harder to ignore the challenge
presented by debt funds. The two serve a similar function and are close rivals. The
primary areas of difference are returns, safety, taxation, liquidity and returns with
mutual funds holding the advantage in tax-adjusted returns and fixed deposits in
safety.
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Safety First
Bank Deposits are one of the safest avenues for savers in India with an almost
negligible chance of default (although there have been instances of co-operative and
local banks defaulting). As with all mutual funds, there are no guarantees in debt
funds. Returns are market-linked and the investor is fully exposed to defaults or any
other credit problems in the entities whose bonds are being invested in. However,
that's a legalistic interpretation of the safety of your investments in mutual funds.
In practice, the fund industry is closely regulated and monitored by the regulator,
Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI
keep tight reins on the risk profile of investments, on the concentration of risk that
individual funds are facing, on how the investments are valued and on how closely
the maturity profile hews to the fund's declared goals. In the past, these measures
have proved to be highly effective and problems have been infrequent such as during
the 2008 crisis and more recently with Amtek Auto and JSPL. Another common risk
faced by debt funds is interest rate risk with funds losing value in a rising rate

scenario and vice versa. Fixed Deposits which have been locked in for long tenures
also face this risk in terms of opportunity cost but there is no actual loss of value
when the deposit is held to maturity.
Taxation
The other big difference is that of taxation. Returns from bank fixed deposits are
interest income and as such have to be added to your normal income. Since many
investors are in the top (30 per cent) tax bracket, this takes away a large chunk of
their returns. Banks also deduct TDS on interest income from fixed deposits. The tax
rates are similar for debt funds held for less than 36 months (though TDS will not
generally be deducted). However for debt funds held longer than 36 months, returns
are classified as long term capital gains and are taxed at 20 per cent with indexation.
Liquidity
Turning to liquidity, open ended debt funds proceeds are credited within a period of
2-3 working days depending on factors such as whether an ECS mandate is
registered. Fixed Deposits are also typically available at 1-2 day's notice, but usually
carry a penalty if they are redeemed before the maturity date. Debt funds also have
exit loads or charges that are usually levied for redemptions, typically upto 3 years.
These exit loads are not applied to liquid funds with just a few exceptions for very
short periods of time.
Returns
As the returns of debt funds demonstrate, you can beat the bank by investing in debt
funds. Debt fund investors assume both credit risk (lending to riskier borrowers) and
interest rate risk (the risk of bond prices falling when interest rates rise) and are
hence compensated by higher returns.
In summary, you can beat the bank by investing in debt funds instead. However you
should be cognizant of the risks involved and choose the right fund in order get the
best possible deal.

All about liquid funds

Liquid funds are a good option for investors who would otherwise
consider a savings account.

The debt fund category has evolved over the years. Based on the their stated goal,
they are classified as liquid funds, short-term, ultra short-term and gilt funds. Within
this universe the liquid funds have for long been the short-term parking ground for
corporate and HNIs for the liquidity they offer.
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What are liquid funds?
Funds which do not invest any part of assets in securities with a residual maturity of
more than 91 days are liquid funds. Currently, the average portfolio maturity of this
category ranges between four and 91 days. These funds invest in short-term debt
instruments with maturities of less than one year. Investments are mostly in money
market instruments, short-term corporate deposits and treasury. The maturity of
instruments held is between 3 and 6 months.
Why invest in liquid funds?
These funds provide good liquidity, low interest rate risk and the prevailing yield in
the market. Liquid funds have the restriction that they can only have 10 per cent or
less mark-to-market component, indicating a lower interest rate risk. While liquidity

is one factor of these funds, safe investments make them the preferred parking
option for HNIs and corporates. Moreover, the maturity makes them relatively less
sensitive to interest rate fluctuations, compared to other debt funds. For all these
reasons, liquid funds are used as an alternative to short-term fix deposits. Most
schemes have a lock-in period of a maximum of three days to protect against
procedural (primarily banking) glitches, and offer redemption proceeds within 24
hours. The minimum investment size in a liquid fund varies from Rs 25,000 to Rs 1
lakh.
The tax advantage
Short-term capital gains tax applies on liquid funds that are held for less than a year
at the income tax slab that one falls in. However, there is tax efficient strategy that
you can adopt. Dividends from liquid funds are tax-free in the hands of investor,
which makes them more attractive than bank fixed deposits. Consider opting for
dividend reinvestment when investing in a liquid fund because dividends stripped
will be reinvested as units and will be considered as fresh investments. This way the
capital gain will be very low. In case you do plan to hold the investment in liquid fund
for over a year; opt for the growth option to benefit from the indexation benefits.

The Range of Debt Funds

Find out how debt funds are categorized & understand the basic
principles behind them...

The categorisation of debt funds is simpler than that of equity funds, once you
understand the basic principles behind it. A debt fund investment like a bond is
defined by two characteristics-its maturity and its credit rating.
A change of interest rates could make a particular bond more or less valuable. When
interest rates fall, older bonds that are locked into a higher interest rates are worth
more. Conversely, when interest rates rise, older bonds that are locked into a lower
interest rates are worth less.
If you think about it for a moment, this
rise or fall in the value has to be proportional to how much time is left for the bond to
become mature. Maturity is the date on which the bond will be redeemed and its
principle amount refunded to investors. This makes perfect sense. For example,
when interest rates fall, all older, higher interest bonds gain value but one which has
(for example) ten years left for maturity should gain more value than one which has
only one year left for maturity. After all, the ten-year one will go on paying a higher
interest rate for so much longer.

Also, from this it is clear that what matters is residual maturity rather than the total
lifetime of the bond. By residual maturity we mean how much time is left for the
redemption date of the bond. In this sense, a twenty-year bond that was issued
eighteen years ago and a freshly issued two-year bond have the same residual
maturity. If other things about these two are the same then a change of interest rates
should impact their value equally.
The risk and return level of a bond is determined by its residual maturity. The
shorter the maturity, the more predictable, less risky and possibly less profitable a
bond will be. Longer maturity bonds will show opposite characteristics. This then
becomes the obvious way of classifying bonds, both in the way fund companies
operate them, as well as the way in which analysts at Value Research evaluate them.
Based on their maturity, we classify debt funds into these types:
Up to 91 days: liquid funds
From 91 days to 1 year (over past 12 months): Ultra-short-term funds
From 1 year to 4.5 years (over past 12 months): Short-term funds
over 4.5 years or those who's maturity vary widely: Income funds
Government Securities: Besides these maturity-based classifications, there also exist
a few other variations. One is that of funds which invest only in government
securities. These securities, which are also called gilts, are bonds issued by the
Government of India. Unlike bonds issued by companies, the chance of the
Government defaulting on its loan obligation is significantly lower.
Fixed Maturity Plans: The funds described above are all open-ended funds. However,
there are also closed-end debt funds that are quite popular and useful. These FMPs,
as they are called, are launched on a specific date for a specific period that can range
from 1 month to 5 years. Investors must enter them at the beginning and normally
stay till the end. Thus, they mean lower liquidity. However, what investors give up in
liquidity, they gain in a combination of predictably higher gains and lower risk that
open-end debt funds cannot offer. FMPs are an excellent alternative to bank fixed
deposits. They generally offer higher returns, especially because they are much more
tax-efficient, because FMPs are taxed as capital gains while bank FDs are just added
to the investors' normal income.
Take together, these categories offer a range of very useful choices for investors
looking for fixed-income options from mutual funds.

A debt fund can bring much value to your overall portfolio, if chosen properly. ET
Wealth helps you decode the basics.
TERMS TO KNOW
Average Maturity: A debt fund portfolio comprises several bonds with varying maturity
dates. Average maturity is the weighted average of maturity for all bonds in the fund
portfolio.
Modified Duration: The duration is the measure of price sensitivity of the portfolio to
change in interest rates. For instance, if interest rates go down (or up) by 1% in a month, the
NAV of the fund will go up (or down) by 4% if modified duration is four years.
Yield to Maturity: The Yield to Maturity (YTM) is what the bond will earn from its coupon
payments as well as annualised gain (or loss) on purchase price, if held till its maturity.
CHOOSING RIGHT
Match time horizon with maturity profile: Ascertain the time period for which you wish to
stay invested and identify a fund with a matching maturity profile
Match risk tolerance with credit profile: Debt funds invest in several instruments, from
risk-free government securities to high-risk corporate bonds. Instruments are assigned a credit
rating indicating the credit worthiness of borrower. Higher the credit rating, safer the
investments.
Ascertain interest rate scenario: When interest rates rise, it makes sense to move to short
term debt funds, while falling rates work in favour of longer duration debt funds.

RISKS INVOLVED
Interest Rate Risk: Debt funds are exposed to risk of interest rate fluctuations, which affect
prices of underlying bonds in the fund portfolio.
Credit Risk: Debt funds are also exposed to the risk of default by the issuer of underlying
instrument. Checking the credit profile of the fund is important. Returns can be enhanced by
lowering credit quality of the portfolio, which enhances the credit risk.
Liquidity Risk: Liquidity is the ease with which a fund manager can sell a particular security
in the market. A fund faces liquidity risk if the fund manager is not able to do so due to lack
of demand for the security.
WHICH FUND IS FOR YOU?
GILT FUNDS
Invests In: All types of government securities of varying maturities.
Risk Factor: High. Zero default risk but high interest rate risk.
Holding Period: 18-24 months
Who Should Invest: Since underlying bond prices will fluctuate wildly, only those who are
comfortable with a high degree of risk and looking for capital appreciation instead of
protection should invest.

SHORT-TERM FUNDS
Invests In: Commercial papers, certificate of deposits and bonds with a maturity of 3-6
months.
Risk Factor: Low. Not affected much by changes in interest rates. HOLDING PERIOD 6-12
months
Who Should Invest: Investors looking to park surplus money, but want to earn higher return
than a liquid fund.

INCOME AND DYNAMIC BOND FUNDS

Invests In: Mix of bonds, corporate debentures and government securities.
Risk Factor: Medium-High. These can shift between maturities aggressively in anticipation
of rate changes.
Holding Period: 3-5 years
Who Should Invest: High risk takers who want to gain from both rising and falling interest
rate scenarios.

CREDIT FUNDS

Invests In: High yield but lower credit quality instruments.

Risk Factor: Medium-High. Low interest rate risk, but default by issuer of underlying bond
and downgrade in credit rating of underlying instrument can hurt NAV.
Holding Period: 3-5 years
Who Should Invest: Investors who do not wish to play the guessing game on interest rates
and are willing to take higher risk for higher yield.

LIQUID FUNDS
Invests In: Highly liquid instruments like treasury bills, inter-bank call money market, etc.
Risk Factor: Very low
Holding Period: Up to 3 months
Who Should Invest: Investors who have surplus money lying idle and seeking better returns
than interest offered by banks.

FIXED MATURITY PLANS

Invests In: Instruments with maturity profile matching fund's tenure.

Risk Factor: Low-Medium
Holding Period: 3 years or more
Who Should Invest: Those looking to park their money for a fixed tenure during uncertain
interest rate movements.
(3 and 5 year returns are CAGR Source: Value Research)

5 tools to evaluate mutual funds

Sep 19, 2011, 11.09 AM IST
ET Bureau
These statistical tools are used by fund managers to understand the risk-reward
profile of a mutual fund.
Though these involve complex formulae, you don't need to calculate all of them.
Simply knowing the final figures and what the ratios indicate will help you
analyse the fund.
Where can you find these tools?
The five indicators: standard deviation, Sharpe ratio, beta, r-squared and alpha
are easily available for free on Websites such as valueresearchonline.com and
morningstar.co.in.
Standard Deviation
It is a measure of a mutual fund's volatility.
HOW TO INTERPRET IT: It measures the degree to which a fund's return fluctuates in relation to its
average return over a period of time. The higher the standard deviation, the more volatile the fund,
and hence, more risky as the fund's performance will rise and fall drastically in a short period of time.
KEEP IN MIND: Usually, as standard deviation increases, so does the return due to the risk-return
trade-off. But if two funds with same investment objectives deliver similar returns, the one with the
lower deviation is a better choice as it maximises the returns for the given risk level.

So, while HSBC Equity and DWS Alpha Equity aim at capital growth from diversified stocks and have
performed similarly, the latter has a higher deviation.
Fund -- HSBC Equity
3-year return -- 4.3%
Standard deviation -- 24.41
Fund -- DWS Aplha Equity
3-year return -- 4.25%
Standard deviation 25.44

Sharp Ratio
The ratio explains whether the fund returns are due to intelligent investment decisions or the result of
excessive risk taken by the fund manager.
HOW TO INTERPRET IT: It is measured by subtracting the risk-free return from the fund's return and
dividing the result by the standard deviation of its return. The risk-free return in India is considered
either to be the bond rate or 181-day treasury bill rate. The higher the ratio, the better is the fund's
risk-adjusted performance.
KEEP IN MIND: A fund may fetch higher returns than its peers, but it's usually a good option only if it
doesn't take too much risk in doing so. Take Reliance Equity Opportunities and BNP Paribas Dividend
Yield. The former multicap fund has earned higher returns, but it also has a lower Sharpe ratio.
Fund -- BNP Paribas Dividend Yield
3-year return - 17.73%
Sharpe ratio - 0.63
Fund -- Reliance Equity Opportunities
3-year-return -- 18.74%
Sharpe ratio - 0.55

Beta
It's also a measure of volatility and tells how risky a fund is in comparison to the market.
HOW TO INTERPRET IT: It measures the sensitivity of a fund's return to swings in the market. The
market's beta is always 1. The index funds' beta value is equal to that of the market. If the beta is less
than 1, it indicates less volatility than the market, and vice-versa.
KEEP IN MIND: Conservative investors whose focus is capital preservation should look at funds with
low betas as their values are less likely to decline than those of the benchmark index in a bear phase.
The table shows the performance of two funds relative to their benchmark (S&P CNX Nifty) during the
bear phase-9 January 2008 to 5 March 2009. Birla Sun Life Asset Allocation Aggressive has a lower
beta and fell less than the benchmark.
Fund -- Birla Sun Life Asset Allocation Aggressive
Returns -- -39.35%
Beta - 0.64
Fund -- L&T Opportunities
Returns -- -63.21%
Beta - 1.22
Fund -- S&P CNX Nifty

Returns -- -52.93%
Beta 1

R-squared
he ratio explains how closely a fund's performance correlates with the performance of the overall
market.
HOW TO INTERPRET IT: It measures the percentage of a fund portfolio's movement that can be
explained by the movement of the benchmark index. R-squared values range from 0 to 1, where 0
indicates no correlation, while 1 indicates perfect correlation.
KEEP IN MIND: Avoid investing in the actively managed funds that have higher expense ratios and
are still perfectly correlated with the index as it will be better to invest in an index fund.
In the example, ING Large Cap Equity has the same R-squared as an index fund. The 3-year returns
of the fund are only 0.5% higher than the index fund, while there is a differential of 1.5 % in the
expense ratio.
Fund -- ING Large Cap Equity
Expense ratio - 2.5
R-sqared - 1
3-year return -- 4.2%
Fund -- Franklin India Index NSE Nifty
Expense ratio - 1
R-squared - 1

3-year return --- 4.7%

Alpha
It quantifies what the fund manager brings or takes away from the return of an investment, which is
based on his skill and value addition that he provides.
HOW TO INTERPRET IT: It is a measure of performance on a risk-adjusted basis. Alpha considers
the price volatility of the fund and compares its risk-adjusted performance with that of the benchmark
index.
The excess return of the fund relative to benchmark index is called alpha. A positive alpha of 1 means
that the fund has outperformed its benchmark index by 1%, and a similar negative alpha indicates an
underperformance of 1%.
KEEP IN MIND: Funds with negative alpha are not good options as it means the fund manager is not
generating any value-added return in excess of the market. The more positive an alpha, the better it
is. In reality, few fund managers create a meaningful alpha that negates the expenses of the scheme.
The table below shows that HDFC Top 200 has generated significant alpha, while UTI Contra has not,
and JM equity has created a negative alpha.
Fund -- HDFC Top 200
Expense ratio - 1.78
Alpha - 7.88
Fund -- UTI Contra
Expense ratio - 1.8
Alpha - 0.21
Fund - JM Equity

Expense ratio - 2.5

Alpha - -7.45

What are Money Markets and money market instruments?

Money markets allow banks to manage their liquidity as well as provide the central bank means to conduct
monetary policy. Money markets are markets for debt instruments with a maturity up to one year.
The most active part of the money market is the call money market (i.e. market for overnight and term money
between banks and institutions) and the market for repo transactions. The former is in the form of loans and the
latter are sale and buyback agreements - both are obviously not traded. The main traded instruments are
commercial papers (CPs), certificates of deposit (CDs) and treasury bills (T-Bills).
Commercial Paper
A Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to the investor. In
India corporates, primary dealers (PD), satellite dealers (SD) and financial institutions (FIs) can issue these
notes.
It is generally companies with very good ratings which are active in the CP market, though RBI permits a
minimum credit rating of Crisil-P2. The tenure of CPs can be anything between 15 days to one year, though the
most popular duration is 90 days. Companies use CPs to save interest costs.
Certificates of Deposit
These are issued by banks in denominations of Rs.5 lakhs and have maturity ranging from 30 days to 3 years.
Banks are allowed to issue CDs with a maturity of less than one year while financial institutions are allowed to
issue CDs with a maturity of at least one year.
Treasury Bills
Treasury Bills are instruments issued by RBI at a discount to the face value and form an integral part of the
money market. In India treasury bills are issued in four different maturities14 days, 90 days, 182 days and 364
days.
Apart from the above money market instruments, certain other short-term instruments are also in vogue with
investors. These include short-term corporate debentures, bills of exchange and promissory notes.
Top

What are debt market instruments?

Debt instruments typically have maturities of more than one year. The main types are government securities
called G-secs or Gilts.
Like T-bills, Gilts are issued by RBI on behalf of the Government. These instruments form a part of the borrowing
program approved by Parliament in the Finance Bill each year (Union Budget). Typically, they have a maturity
ranging from 1 year to 20 years.
Like T-Bills, Gilts are issued through auctions but RBI can sell/buy securities in its Open Market Operations
(OMO). OMOs cover repos as well and are used by RBI to manipulate short-term liquidity and thereby the
interest rates to desired levels:
Other types of government securities include:

Inflation-linked bonds
Zero-coupon bonds
State government securities (state loans)

What is the difference between bonds and debentures?

A debenture is a debt security issued by a corporation that is not secured by specific assets, but rather by the
general credit of the corporation. Stated assets secure a corporate bond, unlike a debenture, but in India these
are used interchangeably.
Bonds are lOUs between a borrower and a lender. The borrowers include public financial institutions and
corporations. The lender is the bond fund, or an investor when an individual buys a bond. In return for the loan,
the issuer of the bond agrees to pay a specified rate of interest over a specified period of time.
Typically bonds are issued by PSUs, public financial institutions and corporates. Another distinction is SLR
(Statutory liquidity ratio) and non-SLR bonds. SLR bonds are those bonds which are approved securities by RBI
which fall under the SLR limits of banks.
Statutory liquidity ratio (SLR) : It is the percentage of its total deposits a bank has to keep in approved securities
Top

What affects bond prices?

Bond prices are primarily affected by 2 factors:

The current interest rate. The price of a bond, and therefore the value of your investment fluctuates
with changes in interest rates. For example, you buy a bond for Rs.1,000 that pays 5% interest. If you hold
the bond until maturity, you get your Rs.1,000 back plus the 5% interest payments you've received from the
issuer. However, between the time you bought the bond and the date it matures, the bond won't always be
worth Rs.1,000. If interest rates rise, your bond is worth less than Rs.1 000. If interest rates fall, your bond is
worth more than Rs.1,000.
The credit quality of the issuer. If the rating agencies change the credit rating of the issuer while you
hold the bond, the value of your bond will be affected. If the credit rating declines, the value of your bond will
also decline. However, if you hold the bond to maturity and the issuer doesn't default, you will get your entire
Rs.1,000 back.
When the bonds are initially priced, the maturity also helps determine the price. Longer maturities tend to
pay higher interest rates than shorter maturities. That's because your investment is exposed to interest-rate
risk for a longer period of time.
Top

What affects interest rates?

The factors affecting interest rates are largely macro-economic in nature:

Demand/supply of money. When economic growth is high, demand for money increases, pushing the
interest rates up and vice versa.
Government borrowing and fiscal deficit. Since the government is the biggest borrower in the debt
market, the level of borrowing also determines the interest rates. On the other hand, supply of money is
controlled by the central bank by either printing more notes or through its Open Market Operations (OMO).
RBI. RBI can change the key rates (CRR, SLR and bank rates) depending on the state of the economy
or to combat inflation. RBI fixes the bank rate which forms the basis of the structure of interest rates and the
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), which determine the availability of credit &
the level of money supply in the economy.
CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash assets and SLR
is the percentage of its total deposits a bank has to keep in approved securities. The purpose of CRR and
SLR is to keep a bank liquid at any point of time. When banks have to keep low CRR or SLR, it increases
the money available for credit in the system. This eases the pressure on interest rates and these move
down.
Typically a higher inflation rate means higher interest rates. The interest rates prevailing in an economy at
any point of time are nominal interest rates, i.e., real interest rates plus a premium for expected inflation.
Due to inflation, there is a decrease in purchasing power of every rupee earned; therefore the interest rates
must include a premium for expected inflation.
Top

What is the yield curve?

The relationship between time and yield on securities is called the yield curve. The relationship represents the
time value of money-showing that people demand a positive rate of return on the money they are willing to partwith today for a payback into the future.
A yield curve can be positive, neutral or flat.

A positive yield curve, which is most natural, is when the yield at the longer end is higher than that at the
shorter end of the time axis. This is because people demand higher returns for longer term investments.
A neutral yield curve has a zero slope, i.e. is flat across time. This occurs when people are willing to
accept more or less the same returns across maturities.
The negative yield curve (also called an inverted yield curve) occurs when the long-term yield is lower
than the short-term yield. It is not often that this happens and has important economic ramifications when it
does. It generally represents an impending downturn in the economy, where people are anticipating lower
interest rates in the future.
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What is yield to maturity?

Yield to maturity is the annualised return an investor would get by holding a fixed-income instrument until
maturity. It is the composite rate of return of all payouts and coupon..
Top

What is the average maturity period?

It is a weighted average of the maturities of all the debt instruments in a portfolio.
Top

What are LIBOR & MIBOR?

LIBOR. Stands for the London Inter Bank Offered Rate. This is a very popular benchmark and is issued
for US Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and the Japanese Yen. The British Bankers
Association (BBA) asks 16 banks to contribute the LIBOR for each maturity and for each currency. The BBA
weeds out the best four and the worst 4, calculates the average of the remaining 8 and the value is
published as LIBOR.
MIBOR. Stands for Mumbai Inter Bank Offered Rate and is closely modeled on the LIBOR. Currently
there are 2 calculating agents for the benchmark-Reuters and the National Stock Exchange (NSE). The NSE
MIBOR benchmark is the more popular of the two and is based on rates polled by NSE from a
representative panel of 31 banks/institutions/primary dealers.
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What is a credit rating ?

Rating organisations evaluate the credit worthiness of an issuer with respect to debt instruments or its general
ability to pay back debt over the specified period of time. The rating is given as an alphanumeric code that
represents a graded structure or creditworthiness. Typically the highest credit rating is AAA and the lowest is D
(for default). Within the same alphabet class, the rating agency might have different grades like A, AA, and AAA
and within the same grade AA+, AA- where the "+" denotes better than AA and "-" indicates the opposite. For
short-term instruments of less than one year, the rating symbol would be typically "P" (varies depending on the
rating agency).
In India, we have 4 rating agencies:

CRISIL
ICRA
CARE
Fitch

What is the "SO" in a rating?

Sometimes, debt instruments are so structured that in case the issuer is unable to meet repayment obligations,
another entity steps in to fulfill these obligations. A bond backed by the guarantee of the Government of India
may be rated AAA (SO) with the SO standing for structured obligation.
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How is a currency valued?

The floating exchange rate system is a confluence of various demand and supply factors prevalent in an
economy such as:

Current account balance. The trade balance is the difference between the value of exports and
imports. If India is exporting more than it is importing, it would have a positive trade balance with USA,
leading to a higher demand for the home currency. As a result, the demand will translate into appreciation of
the currency and vice versa.
Inflation rate. Theoretically, the rate of change in exchange rate is equal to the difference in inflation
rates prevailing in the 2 countries. So, whenever, inflation in one country increases relative to the other
country, its currency falls.
Interest rates. The funds will flow to that economy where the interest rates are higher resulting in more
demand for that currency.
Speculation. Another important factor is the speculative and arbitrage activities of big players in the
market which determines the direction of a currency. In the event of global turmoil, investors flock towards
perceived safe haven currencies like the US dollar resulting in a demand for that currency.
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What are the implications of currency fluctuations on debt markets?

Depreciation of a currency affects an economy in 2 ways, which are in a way counter to each other. On the one
hand, it makes the exports of a country more competitive, thereby leading to an increase in exports. On the other
hand, it decreases the value of a currency relative to other currencies, and hence imports like oil become dearer
resulting in higher deficits.
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What is Real Effective Exchange Rate (REER) and currency over valuation?
When RBI says that the rupee is overvalued, they mean that it has been appreciating against other major
currencies as they weaken against the dollar, which might impact the competitiveness of India's exports.
REER is the change in the external value of the currency in relation to its main trading partners. It is rupee's
value on a trade-weighted basis. It takes into account the rupee's value not only in terms of major currencies
such as the US dollar, euro, yen and pound sterling.
The exchange rates versus other major currencies are average weighted by the value of India's trade with the
respective countries and are then converted into a single index using a base period which is called the nominal
effective exchange rate. But the relative competitiveness of Indian goods increases even when the nominal

effective exchange rate remains unchanged when the rate of price increases of the trading partner surpasses
that of India's. Taking this into account, prices are adjusted for the nominal effective exchange rate and this rate is
called the "real effective exchange rate."