Realised gain

A scheme buys a bond at Rs 98. The bond is quoted at Rs 105 today. Has the scheme made Rs 7?

On paper, yes. The NAV picks it up, because holdings are valued at market prices every day.

In money, no. The scheme still owns the bond. The price can fall back tomorrow.

The gain becomes a realised gain only when the scheme sells. Until then it is a valuation gain.

The workbook draws the line hard. Accrued income is money the scheme will get — it is only a question of time. A valuation gain is not like that at all. It may never become a real gain, because the security has to be sold first.

That one distinction decides what a scheme may hand out as income. The NAV counts paper gains. A dividend does not.

Chapter 7 section 7.3 puts it plainly: since the investments have not been sold, the gains in them are on paper — they are not realised, and they will be realised when those investments are sold.

Both kinds of gain reach the NAV. The scheme's profitability lines in Chapter 7 are separate and symmetrical: + realised capital gains, + valuation gains, − realised capital losses, − valuation losses, alongside interest income, dividend income and scheme expenses. The Chapter 7 illustration makes it concrete — of the Rs 217 crore of net assets in the worked scheme, Rs 14 crore is capital appreciation on investments still held, and not a rupee of it has been realised.

What separates the two kinds is what may be distributed. In computing distributable reserves:

• all profits earned on the accrual basis are available for distribution;
• valuation gains are ignored;
• valuation losses must still be adjusted against profits;
• the portion of the sale price of new units attributable to valuation gains is not available either.

The workbook calls this the conservative approach, and says its purpose is to ensure dividend is paid out of real and realized profits, after providing for all possible losses. Note the asymmetry, because it is where the marks are: a gain has to be realised to count, but a loss counts the moment it appears.

One realised gain travels a different route. A certain proportion of the sale price of a scheme's investments represents realised gains that are credited to an equalisation reserve, which can also be used to pay dividends — which is why a payout has to be split on disclosure into NAV appreciation and capital distribution.

The same word does duty for the investor. Chapter 1 notes that current income arrives periodically without selling anything, whereas capital gains can be realised only when one sells the investment.

A short duration debt scheme with 2 crore units reports for the year (figures illustrative, the rules are the workbook's):

Net assets grew by Rs 0.90 crore, which is Rs 0.45 per unit. The most the trustees can distribute is Rs 0.40 crore, or Rs 0.20 per unit. The Rs 0.50 crore of unrealised appreciation is in the NAV and cannot be paid out; the Rs 0.20 crore of unrealised depreciation has already been taken off the distributable figure.

Now the fund manager sells Bond B for Rs 6.50 crore. That Rs 0.50 crore is now realised, and distributable reserves jump to Rs 0.90 crore, or Rs 0.45 per unit. Nothing about what the portfolio was worth changed. Only the sale did.

For the investor the word turns up again at exit. Chapter 8's grandfathering illustration hinges on it: units worth Rs 2,00,000 on 31 January 2018 and a realised value of Rs 1,80,000 on sale give a taxable long-term gain of zero, while a realised value of Rs 2,20,000 gives a gain of Rs 20,000.

Chapter 7 (Net Asset Value, Total Expense Ratio and Pricing of Units), section 7.3, is built on the realised-versus-unrealised distinction, and section 7.2 lists the realised and valuation lines separately in the scheme's profitability. Chapter 1 supplies the investor-side sense and Chapter 8 uses "realised value" in the grandfathering arithmetic. Expect a question on why valuation gains are ignored in distributable reserves while valuation losses are not, and on what a dividend may be paid out of.

• A realised gain raises both NAV and distributable reserves. A valuation gain raises only NAV. That is the whole test.
• Valuation losses are deducted from distributable reserves even though unrealised. Gains wait for a sale; losses do not.
• Realised is not the same as accrued. Accrued income has not been received but will be; an unrealised gain may never arrive.
• Mark-to-market profit is not a source of dividend. Neither is unit capital nor a premium reserve.
• A realised gain embedded in the price a new investor pays goes to the equalisation reserve — which is why part of a declared dividend can be a return of the investor's own capital.
• The scheme realising a gain and the investor realising one are two different transactions. The scheme selling a bond feeds distributable reserves; the investor selling units triggers long-term or short-term capital gains tax in the investor's own hands.