Those of you who have been paying attention to your debt portfolios during the months of August and September 2013 may have wondered what was going on.

If you were subscribed to daily text messages for dividends on your liquid funds, there would have been a hushed silence for many days in the last two months.

Some of you, particularly relatively recent investors in medium term to longer term debt funds, may have noticed a strange and worrying depreciation in your portfolio, showing a capital loss in some cases.

Subscribers to fixed maturity plans during this period may have noticed a similar capital loss immediately upon making the investment.

All of which leads to a terrifying question: I can lose money by investing in a ‘safe’ debt instrument?!? Seriously?

Well, the answer, as is so often the case with answers revolving around investing, is Yes and No.

If you don’t have the time and/or the inclination to read what follows, here’s all you need to take on trust:

Your debt investments may look like they’ve lost money, but if you stay invested, you won’t lose and if you invest today, returns are actually higher than what they used to be, but the world is also a bit of a riskier place (and since you don’t have any other world to go to at the moment, grin and bear it).

(For our more savvy Squirrels, what follows may seem simplistic, but bear with us for the sake of our less savvy Squirrels who do have the attention span required for what follows.)

To explain, let’s do a quick, simplified recap of what happened in those few days in August and the reverberations through September (and beyond). This will necessarily get a bit technical and for those Squirrels whose eyes glaze over at words like finance, economics and fiscal, sorry, but enlightenment never comes easy.

First, a fact: by far the largest group of investors in Indian markets (both equity and debt) are no, not Indians, but foreign investors. These foreign investors bring money into the Indian markets and invest in them, not because they love us more, but because they expect higher returns from our markets. They are of the opinion that the risks in investing in a foreign (to them) market are higher but they expect to compensate for these risks by earning a higher return. No surprises there.

Next, a bit of background: Over the last few years, particularly since the global financial crisis of 2008, the US Federal Reserve (aka the Fed, which is kind of their equivalent of our RBI) has been attempting to soothe markets, restore confidence, kickstart the US economy and do similar laudable things by following a policy of what is called “quantitative easing”. While this sounds vaguely like something you and I might do the morning after a particularly heavy dinner, in fiscal terms it means that the Fed has promised the markets that every month it will buy from all and sundry a stack of debt and give back a wad of cash for them to go out and splurge on such things as investing in deserving investments, making loans and so on, all the while ensuring that interest rates remain low. For example, in September 2012 (a year ago) the Fed announced it would do this to the tune of $40 billion each month until further notice! That is a lot of money. To put it in perspective somewhat, The IFMR Trust reported that in 2011, the outstanding issue size of Government securities (Central and State) was close to Rs. 29 lakh crores or $644.31 billion – which means that theoretically, in about 16 months, the funds available via QE could buy out the entire debt of our Indian government!

If interest rates are low, the argument goes, it encourages people to borrow and invest and spend and generally contribute towards boosting the economy. However, it also encourages those who have money to invest, to look for investment opportunities that offer a better return than the rate they’re getting in their own countries.

Enter India.

Over the last few years wads of foreign money have poured into our debt markets looking for a better return than the paltry few percentage points available in the US and elsewhere.

Now, the zinger.

In August, the Fed announced by way of what is called “forward guidance” that since the US economy seemed to be recovering, at some time in the future it would start tapering off QE, i.e., reducing and perhaps stopping the flow of funds made available via QE. No real fixed dates or amounts were given and this “tapering” should have been no surprise since sooner or later QE, which has never been touted as a permanent fixture, would have to grind to a halt.

However, markets being markets, the announcement threw them into a frenzy.

The argument went something like this: If QE is stopping, then the flow of money is stopping, the tap is being turned off. Also, if QE is stopping, then the US economy is recovering, so interest rates will start rising there. If interest rates start rising there, why do we need to be in relatively riskier economies like India? We should get our money out while we can and move it back to the US. And if we are to stay in relatively riskier markets like India, we should be getting a higher return to compensate for the higher risk. And we mean now.

(Some of this is logical and rational and some of this is sentiment. In the short-term, a surprising proportion of actions, even in the markets, is sentiment-driven and it tends to have a multiplier effect for a while.)

So, in the rush for the exit, our debt markets got trampled upon. Like so:

If the market wants a higher return there are two likely ways to get it: invest in debt that offers a higher interest rate; if such debt is not immediately available, then pay a lower price for existing debt so that the return becomes higher. Since new debt at a higher return was not immediately available (naturally, since these things take more than a few hours to put in place), the only option was to push down the price of existing debt so you could buy more debt for the same amount of cash and thereby get a higher return on your investment.

Which is where your debt fund investment starts getting clobbered.

When you invest in a debt fund, the fund is actually in turn investing in real debt, i.e., borrowings by our Central, state and municipal governments, by our banks, our public sector companies and our private sector companies. Now, because of accounting rules and transparency rules, when the market price of an investment goes down, the fund needs to re-value its investment at the new price. This re-valuation is called “marking to market”.

So, when bond prices got pushed down (and how!), the funds were forced to revalue their investments, resulting in an often precipitous fall in NAVs. For daily dividend liquid funds, this meant that until bond values recovered, no daily dividend could be declared (hence the SMS silence), because the interest accrued daily on the bonds went towards making up the bond price to the original level.

Longer term bonds got clobbered more, because the longer term is necessarily more uncertain. So longer term debt funds will show lower NAVs for longer.

What does all this mean for you as an investor?

Firstly, recognise that the underlying investment hasn’t really changed. If the fund invested in say, a bank certificate, the credit risk associated with that and the return on that investment hasn’t changed for the fund (since the investment has already been made; though any new investment will be made at the new return).

Secondly, understand that in debt investing, there is an interest meter ticking away (unlike in an equity investment), so with the passage of time, interest will continue to accrue and NAVs will rise again. So, while the fund may have lost the opportunity to make capital gains (since bond prices are falling, they can’t sell their existing holdings at a higher price than they bought them), they’re still earning interest.

Taking these two together, it means that over time (and other things being equal), debt funds will recover. If you exit when NAVs fall, yes, you will lose money. But if you stay invested, your investment will recover in value.

And now, since interest rates are higher, if you make a fresh investment, you’ll actually probably get a higher return than you would have a couple of months ago.

So, two rules to live by:

– Stay invested

– Keep investing

No surprises there.