Just in case you are new to this blog (which most probably you will be :)), you can read the first part of this series here Link

**Debt Fund Returns
=
Interest from underlying debt securities
+
Price changes in the market value of underlying debt securities
(based on interest rate changes)**

or in other words..

**Debt Fund Returns
everyday = (Yield to maturity/365) + (-1*Modified duration*
% change in YTM)**

**8 factor framework
for investing in any debt mutual fund**

*Yield to Maturity – Expense Ratio**Credit Quality**: % of government, AAA and AA rated bonds**Modified Duration*- Average Maturity
*Size**Exit Load**Historical NAV movement graph**Returns*

**1.Yield to Maturity – Expense ratio
**This will approximately be equal to
the returns that you can expect from the fund in a year if there is no change
in the interest rates (read as yield to maturity)

**2.Credit Quality: % of government and AAA rated
bonds**

This is to check if the fund is taking any credit risk. The ** higher the % of AAA and government securities in the portfolio of
debt mutual fund, lower is the credit risk i.e probability of default or
downgrade in the fund**.

*Even AA papers are fine to a certain extent.*A debt fund which is taking** credit risk** will have a

**(because when you are lending to a lower rated borrower you would demand a higher interest rate). So the Yield to maturity level compared to other funds can also be used as a proxy to find out if the fund is taking credit risk.**

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*I personally prefer funds which do not take credit
risk and have a high % portfolio allocation in either government bonds or AAA
securities.*

**3. Modified Duration
**Check this number

**to figure out if the fund is undertaking any interest rate risk**. Higher the modified duration higher is the interest rate risk i.e sensitivity to interest rate changes. Also

**check if the modified duration will be actively managed**i.e will the fund manager regularly adjust the modified duration based on his interest rate view. If the fund is actively managed then the fund manager will typically try to increase duration if he expects interest rates to fall and vice versa.

**4.Average Maturity **

This no in my personal opinion is not too important but provides you a sense of
tenor of the debt securities that the fund holds. The lower the tenor the lower
is the interest rate risk. Few also interpret this number (some also use
modified duration) as an approximate indicator of the time for which an
investor must typically be invested in the fund. It is also used to ascertain
the category of the fund. (Liquid, Ultra Short Term, Short Term, Income – in
increasing order of average maturity)

**5.Size
**Fund size is important as flows are normally
of a significant size (because corporate companies are
major investors in debt funds). Further, trading in the debt market
requires huge minimum lots. A reasonably sized debt fund helps the fund manager
to meet redemptions (read as investors taking money out of the fund) without
resorting to distress sales and also provides sufficient size to trade in
debt securities. Personally,

**I would be comfortable with a fund that has a size more than INR 500 cr at least.**

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**6.Exit Load**An Exit Load is the fee charged by
mutual funds if an investor wishes to withdraw his investment in mutual fund
within a specified period from that fund. This charge is calculated as a
percentage of the NAV and not on the amount you invest. *The lower the exit load period the better!!*

**7.Historical NAV movement graph
**Provides you a

**in the returns of the fund.**

*sense of the historical volatility***8. Returns**

Also just have a look at the fund’s historical returns and its performance
vis-a-vis the peer group. We typically need a fund which has *performed over a long period** *and most importantly has *done it** consistently*.

Enough of theory, let’s take the example of a few funds and apply the framework..

I will be using value research online (link) and morningstar website (link) for all my analysis

**Example 1: HDFC Liquid Fund – Growth**

**1.YTM – Expense Ratio**

= 7.28%-0.41% = 6.87%

So 6.87**% is the annual return to be
expected from the fund if the YTM remains the same**. Expense ratio
seems reasonable.

Daily stable return portion = 6.87%/365 =0.019% every day gets added to the NAV

i.e for every Rs 1 lakh invested Rs 19 will get added everyday

**2.Credit Quality **

As seen above ~98.5% of the underlying debt
securities are in AAA bond securities. Hence **the fund is not taking any
credit risk to improve performance**.

But, the fact that the fund is not taking any credit risk right now does not mean that it won’t take any credit risk in the future. So let us also check its historical credit quality for getting a better idea.

As seen above the fund has historically maintained above 98% in AAA bond securities for the last 5 years and therefore we can reasonably conclude that the fund does not take credit risk.

**3. Modified Duration**

The modified duration is 0.14 years. This implies
that if the interest rates (read as YTM) goes down by 1% (i.e from 7.28% to
6.28%) then the NAV will increase by 0.14% and if instead the interest rates
goes up by 1% then the NAV will reduce by 0.14%. Thus as seen, the impact due
to interest rate changes are minimal as the fund has low modified duration.This
also implies that the fund **has not undertaken any interest
rate risk to improve returns**.

**4.Average Maturity**

The average maturity is 0.14 i.e 0.14*365 which is around 51 days. This will also help us ascertain the category of fund (but let us leave that for the next post).

**5.Size**

The size is at Rs 30,622 cr and is comfortably above our threshold of Rs 500 cr.

There is no exit load for the fund which is good.

**7.Historical NAV Graph**

From our analysis so far, we know that t**he fund does not take credit risk and interest rate risk.** Hence
the **returns must be pretty stable** as it is **only driven by the interest income which is the YTM (Yield to
maturity) component**. We can confirm that from the above 10 year NAV
movement chart of the fund which shows extremely smooth movement in NAVs.

**8.Historical Returns**

You can check them from the above chart. As seen, the fund has consistently outperformed its category average in all the years.

**Final thoughts:**

Thus if I were to invest in the fund **I will expect approximately around 6.87% returns from the fund
provided interest rates stay around the same levels**. If interest
rates go down then my returns will also go down (as the YTM component goes down
and so does your daily return i.e YTM/365) and if instead the interest
rates go up then my returns will also correspondingly improve. (Note: Since
modified duration is very low I am not taking into account the underlying debt
security price changes due to interest rate movement.)