Monday, December 03, 2007


Debt Funds

The prodigal son …

The debt fund I invested in returned only 5% last year. I would be better off (earning nearly double that amount) investing in the fixed deposit of my bank.” So went the common investor refrain... With an average 3-year return of 4.7 per cent, these funds had little to offer investors who were seeing their equity fund portfolios returning 48 per cent in the same period. Bank Fixed Deposits (FD) and Post Office Monthly Investment Schemes (POMIS) had supplanted debt funds. But all this is passe. Debt funds are making a comeback. With interest rates expected to soften in the long term, debt funds are radiating their new-found brilliance.

Time to delve deep into Debt Funds

Fixed Income/ Income/ Debt Funds are funds that invest in short, medium and long-term debt instruments issued by private companies, banks, financial institutions, governments and other entities belonging to various sectors. The debt instruments are obligations on the part of the issuer to pay the principal and interest thereon as per an agreed time schedule. Debt funds are funds that seek to generate fixed current income (and not capital appreciation). So, debt funds distribute a large fraction of their surplus to you. Fixed Income Funds can be further classified into:

Bond Funds

Bond Funds generally invest in bonds with good rating issued by reputed banks, companies and public infrastructure development bodies having fixed maturity and interest rate. Though the focus is on regular income, the capital value of the investments, traded in the open market for the same maturity, may also fluctuate depending on changes in prevailing interest rates. Another investment avenue for funds investing in corporate debt is securitisation transactions. Securitisation involves conversion of a pool of financial assets into a structured financial instrument which can be sold to a buyer and subsequently traded.

Gilt Funds

Gilt Funds invest in gilts which are debt securities, like dated securities and treasury bills, issued by the government. They are called gilts because government security documents used to be issued with their edges coated in gold to emphasise highest security. The values of gilts also fluctuate depending on the varying maturities, prevailing interest rates and the demand for such securities from large institutional investors like banks.

Money Market / Liquid Funds

Money Market Funds invest in the money market - the market for very short term borrowings mostly by banks and other financial institutions to meet immediate requirements. The maturity of such borrowings can be as short as one day. Interest rates will depend on the overall liquidity position in the financial system - high when sufficient funds are not available in the market and vice versa. Money market transactions are highly secure as the borrowers are the best banks and financial institutions. Retail investors cannot participate in money market transactions as the value of individual transactions is very high. Money Market Funds offer an opportunity for retail investors to participate in this relatively more secure and highly liquid market for short term funds.

Diversified Fixed Income Funds invest in all kinds of debt securities like bonds, gilts, money market instruments, etc. They keep their investment options wide and have the flexibility to move from one type of assets to another.

The risk – return trade off

The returns from a debt fund are essentially the weighted average of the returns on each of its investment, weighted by the proportion of invested sum. Returns are determined by the quality of papers and average duration of the portfolio. However, the prices and yields of debt instruments can fluctuate like other investments and so there is some risk inherent even in debt funds and they are not absolutely risk-free as they are often made out to be. Although debt securities are generally less risky than equities, they are subject to interest rate risk, credit risk (risk of default) and delay risk by the issuer at the time of interest or principal payment. To minimize the risk of default, debt funds usually invest in securities from issuers who are rated by credit rating agencies and are considered to be of "Investment Grade". The greater the risk of a debt fund, the higher the potential return.

Investment in debt should necessarily form a part of your portfolio, more so in the case of people on the verge of retirement or those with moderate risk appetite. Debt Funds offer the much needed diversification to a portfolio, thereby, aiding rebalancing and lending good risk-adjusted returns. Debt funds are primed to give good returns along with lower volatility, liquidity, convenience and tax efficiency. Debt Funds have to pay a dividend distribution tax of 15 per cent but dividends from debt funds are exempt from tax. and long-term capital gains from debt funds are taxed at 10 per cent or 20% after reducing the rate of inflation (indexation benefit).

Welcome with moderation and not a banquet!

While there is no doubt about the bond market’s resurgence, you should wait for an easing trend in interest rates backed by a sustained fall in inflation, before committing funds. The bond markets may see some uncertainty in the short term, before they stabilise and rally. Hence, depending on your ability to stomach uncertainty, you can wait for more clarity on interest rates before entering debt funds, or enter them in tranches over the next couple of months.

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