I am considering investments in debt mutual funds. As per my understanding, the NAV of an equity mutual fund is calculated on the basis of the market price of individual scrips bought by the fund from the stock market. But in a debt mutual fund, most of the securities invested in by the fund may not be traded frequently in the market. So how is the NAV calculated for a debt mutual fund? Please also explain whether the NAV of debt mutual funds comes down if the interest rate in the economy goes up.
James Thekkan
It is true that trading volumes in the bonds held by mutual funds may not be as high as those in stocks in their portfolios. This makes the valuation of non-traded or thinly-traded debt securities a subjective exercise. However, in recent years, the Securities and Exchange Board of India and industry body AMFI have tried to usher in greater standardisation and uniformity in the valuation of debt securities held by mutual funds by prescribing certain valuation norms.
Generally, treasury bills, government securities, money market instruments and bonds of PSUs or AAA-rated companies tend to be quite frequently traded in the Indian markets. A high proportion of debt mutual fund assets are invested in these securities. Their traded price, therefore, tends to get reflected in the debt funds’ NAV, just like the traded market price of stocks gets reflected in the NAVs of equity funds. However, trading in lower rated bonds in India’s corporate bond market tends to be sporadic. Market-based valuation may not always be possible for funds that hold the major portion of their portfolios in corporate bonds rated AA or below.
SEBI has defined what are traded debt securities and what can be termed as non-traded securities. Traded securities are bonds that are traded in marketable lots on the exchanges or captured on reporting platforms. According to SEBI’s valuation guidelines, traded debt and money market securities are required to be valued at their weighted average traded price on each day sourced from the exchanges.
Securities that are non-traded must be valued based on the spreads (higher rates) at which similar securities trade in the markets when compared to the risk-free benchmark on each day. This risk-free benchmark is usually the government security of similar tenure. To simplify, if a fund has invested in an AA-rated bond that hasn’t traded, its valuation will be decided based on the yields at which AA bonds with a similar risk profile trade in the market. A matrix of market spreads for such valuation is shared by the rating agencies. All funds are required to adhere to this matrix for their debt fund portfolio valuation.
Earlier, valuation for short-term securities up to 30 days held by liquid funds used to be based on amortisation, where the security’s value was determined by the interest accrued on a daily basis and not by market prices. But all debt instruments have now been moved to a market-based valuation and this anomaly has been done away with.
A second issue with debt security valuation arises when they suffer defaults or downgrades. Earlier, when debt securities suffered a default or downgrade, funds used different subjective criteria to mark down their value in their portfolios, with no uniformity in treatment. However, AMFI has now prescribed a standard valuation matrix that decides how much of a haircut a debt fund needs to take on a bond, in the case of defaults or downgrades. While this matrix is prescriptive, funds do have flexibility to take discretionary calls on fair valuation in such cases. You may still find instances of different fund houses valuing the same bond differently in case of downgrades.
Thus, investors in debt funds need to be watchful on valuation when it comes to funds investing in corporate bonds, credit risk funds investing in lower rated bonds and in the case of funds that have suffered defaults or delays in securities held in their portfolios.
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