Debt mutual funds are different from bank fixed deposits

“That's exactly how I feel,” she said, as soon as she entered my room with a view, overlooking the bus depot.

Johnny Cash was singing I fell into a ring of fire.

“What happened?” I asked.

“You haven't heard the news?” she asked.

“I was taking a nap, just woke up,” I replied.

“The NAVs of many debt mutual fund schemes have come down,” she said.

“So?”

“Nothing surprising there?”

“No. There are no guarantees when it comes to debt mutual funds or any other mutual funds for that matter.”

“Are you sure?” she asked.

“Of course.”

“I thought they are like fixed deposits.”

“They aren't.”

“Can you explain?”

“For sure.”

“Let me make some coffee first,” she replied. 

Five minutes later, the coffee was made. “Now tell me V,” she said, feeling slightly refreshed.

“You invest in a debt mutual fund and buy units at a certain net asset value (NAV).”

“Right,” she said.

“Depending on the NAV, units are allocated.”

“Yes.”

“Now the mutual fund has your money.”

“Yes.”

“What do you think it does with it?”

“You tell me. You are the expert here V.”

“The money is invested in debt securities issued by corporate, non-banking finance companies (NBFC) and the government, depending on the type of debt fund you have invested in. So, what does this mean?”

“I am in a bad mood V,” she replied. “Give me the answers, don't ask questions.”

“Okay.” “A debt mutual fund invests in debt securities. Now all debt securities have a certain period of maturity. The mutual fund, depending on its strategy can hold on to the securities till they mature or sell them before they mature, and reinvest that money in some other security.”

“Hmmm.”

“Now let's say that the mutual fund decides to hold on to a few debt securities that it has invested in, until maturity.”

“Okay.”

“Of course, the assumption here is that on the date of the maturity, the institution issuing the debt security, will repay the principal amount and pay the interest that is due,” I explained.

“Makes sense,” she said.

“Now what happens if the institution which has borrowed money from the mutual fund, does not repay the money that is due on the date of maturity?”

“In case of a default, the mutual fund doesn't get its money back.”

“Exactly. And when the mutual fund does not get its money back, depending on the money invested in the debt securities, its NAV, which is essentially a reflection of the value of the mutual fund, will come down.”

“Now I get it.”

“Recently, an NBFC defaulted on its payment that was due to many debt mutual funds.” 

“Yes.”

“A few debt mutual funds had bet a lot of money on debt securities issued by this NBFC. When the NBFC did not repay, the mutual funds lost that money and that led to a fall in NAV. This means that the value of the investment made by the investor came down.”

“Now I get it,” she replied. “But how is it different in case of fixed deposits?”

“The deposits we invest with banks are given out as loans. Of course, for depositors to get their money back, these loans need to be repaid. Let's say a large loan is not repaid. What happens then?”

“You tell me.”

“The bank tries to recover the loan by selling the collateral that it has against the loan. But if it doesn't manage to recover the loan, the depositor does not pay for it. The bank takes the hit, first on its profit and later on its capital. Also, in this day and age, if the bank reaches a stage where it is about to collapse, it is likely to be rescued by the central bank.”

“So, depositing money with a bank is less risky?” she asked.

“Any day and which is why returns are also lower.”

The example is hypothetical.

Vivek Kaul is the author of the Easy Money trilogy.