How we earn from debt funds?

Question

I was guessing how we earn from debt funds. I know the underlying bonds pay back interest. But I want to know how exactly we earn from debt funds.

I know how NAV of the fund increases in decreasing interest rate cycle. This increases NAV of existing funds. I guess, repo rate and reverse repo rate also affect NAV.

Q1. Does change in NAV due to above reasons is also one of the ways fund unit holders earn?

Q2. Does interest earned on underlying bonds reflect on NAV? If yes, then how? If not, then how the interest on underlying bonds is paid back to fund customers/unitholders?

I currently hold growth debt funds which incur NAV changes as described above. Earlier I had invested in daily dividend reinvestment debt scheme. In this scheme, the dividend earned daily was reinvested in buying more units of the scheme. But, as long as I recall it correct, the NAV of this scheme remained same till I withdraw my money.

Q3. Does the NAV of daily dividend reinvestment schemes dont change due to above reasons?

Answer 1

Q1. Does change in NAV due to above reasons is also one of the ways fund unit holders earn?

Yes, when the interest rates fall, the price of the old bonds with higher coupon goes up.

Q2. Does interest earned on underlying bonds reflect on NAV? If yes, then how? If not, then how the interest on underlying bonds is paid back to fund customers/unitholders?

This varies from fund to fund. Some pay the interest income back, others use it to buy more bonds, just like equity schemes.

Q3. Does the NAV of daily dividend reinvestment schemes dont change due to above reasons?

There could be many reasons for no change in NAV, for ex - the fund manager might have kept the cash as a reserve. There is no single right answer to this.