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OMG! I lost money in debt funds

Lately, debt funds have been making lots of news. Numerous articles and opinions have been published since the stringent RBI measures a couple of weeks back led to debt funds incurring huge losses in a single day. If fact, even the liquid funds where the possibility of negative returns is pretty remote, ended up with -ve returns.

Given the confusion, misconceptions and the fears that have been generated, let me try and de-mystify the whole drama. Let me try and cut out all the noise and go back to the basic facts.  

1. The fact that NAV of debt funds fell has nothing - absolutely nothing - to do with the mutual funds per se. There was no fault, slip-up, gaffe or mistake on part of the MFs.

2. NAV of debt MFs is calculated based on the prices of the bonds that it holds (similar to the NAV of an equity MF which is calculated based on the prices of shares that it holds)

3. Now just as share prices fluctuate every day, the bonds prices too fluctuate every day. (Since people don't trade in debt and generally hold their bonds till maturity, they are unaware of these fluctuations)

4. Fluctuation in bond prices is based on the prevailing interest rates movements. This relationship is inverse. If rates rise, bond prices fall. If rates fall, bond prices rise. There is a very very simple mathematics behind it, which I explained some time back. [See blog 'Why Gilts (and bonds) are prone to interest-rate risk?']

5. When RBI took stringent measures to protect the rupee, the rates were sharply increased on a single day. This happens on very rare occasions. Sharp rise in interest rates, consequently led to sharp fall in bond prices and hence the debt MF NAVs fell too. Such sharp movements are a rarity. Hence, even the very safe liquid funds too gave a very rare -ve returns.

6. Since sharp interest rate movement are rare, fall in NAV of debt funds too is rare...especially the ultra short-term, short-term and liquid funds. So investors should not get too much worried by such rare events. Debt MFs were and still are a much better investment option than Bank FDs for those in the higher tax brackets. In fact, people have lost much more money in company FDs or co-operative bank FDs than in debt funds ever.

7. Moreover, this -ve returns could well turn out to be only a notional loss. If you continue holding your debt funds for next few months and in the interim RBI reverses these temporary stringent measures, you will see interest falling back to normal levels and hence bond prices going back to original levels. 

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