FUND FLAVOUR

December 2017

What are Debt Funds?

When you buy an equity instrument like a stock, you buy ownership into that company to participate in its growth. But when you buy a debt instrument, you give a loan to the issuing entity. The government and private companies issue bills and bonds to get a loan to run their operations. The interest you can earn from these debt securities is pre-decided along with the duration after which the debt security will mature. This is why these securities are called ‘fixed income’ securities, because you know what you are going to get out of them. Debt funds invest in such fixed income securities, and just like equity funds, they try to optimise returns by diversifying across different types of securities. This allows debt funds to earn decent returns, but there is no guarantee of returns. The two main components of returns of debt funds are interest income and capital appreciation/depreciation in the value of the security due to changes in market dynamics. However, debt fund returns can be expected in a predictable range, which makes them safer avenues for conservative investors. Debt securities are also assigned a 'credit rating', which helps assess the ability of the issuer of the securities/bonds to pay back their debt, over a certain period of time. These ratings are issued by independent rating organisations such as CARE, CRISIL, FITCH, Brickwork and ICRA. Ratings are one amongst various criteria used by fund houses to evaluate the credit worthiness of issuers of fixed income securities. There is a wide range of fixed income or Debt Mutual Funds available to suit the needs of different investors, based on their investment horizon and the ability to bear risk.

The different types of securities Debt Funds invest in

Debt funds invest in different securities that have different credit ratings. A security’s credit rating signifies the risk associated with the entity that is issuing the security. A higher credit rating means that the entity is more likely to pay interest on the debt security as well as pay back the principal amount upon maturity. This is why debt funds that invest in higher-rated securities will be less volatile than those that invest in low-rated securities.

Another factor that determines the kind of securities that debt funds invest in is the maturity of that security. Different types of debt funds invest in securities that mature after different time periods. Shorter the maturity period, less volatile the debt security can be expected to be.

Types of Debt Funds

Just like equity mutual funds, debt mutual funds also come in various types. The primary differentiating factor between debt funds is the maturity period of the instruments they invest in. Here are the different types of debt funds.

Dynamic bond funds

As the name suggests, these are ‘dynamic’ funds, which means that they are not fixed to a certain maturity period. Dynamic bond funds have a fluctuating average maturity period because these funds take interest rate calls and invest in instruments of longer as well as shorter maturities.

Income funds

Income funds invest in a variety of fixed income securities such as bonds, debentures and government securities, across different maturity profiles. For example they can invest in 2 to 3 year corporate non-convertible debenture and at the same time invest in a 20 year Government bond. Their investment strategy is a mix of both hold to maturity (accrual income) and duration calls. This enables them to earn good returns in different interest rate scenarios. However, the average maturities of securities in the portfolio of income funds are in the range of 7 to 20 years. This makes them more stable than dynamic bond funds.

Short-term and ultra short-term debt funds

Short term bond funds invest in Commercial Papers (CP), Certificate of Deposits (CD) and short maturity bonds. The average maturities of the securities in the portfolio of short term bond funds are in the range of 2 – 3 years. The fund managers employ a predominantly accrual (hold to maturity) strategy for these funds. Short term debt funds are suitable for investors with low risk tolerance, looking for stable income.

Liquid funds

Liquid funds invest in debt instruments with a maturity of not more than 91 days. This makes them almost risk-free. Liquid funds have seen negative returns very rarely. These funds are good alternatives to savings bank accounts as they provide similar liquidity and higher returns. Unlike savings bank interest, no tax is deducted at source for liquid fund returns. There is no exit load. Withdrawals from liquid funds are processed within 24 hours on business days. Liquid funds are suitable for investors who have substantial amount of cash lying idle in their savings bank account.

Gilt funds

Gilt funds invest only in Government securities with varying maturities. Average maturities of government bonds in the portfolio of long term gilt funds are in the range of 15 to 30 years. Government securities are high-rated securities and do not come with a credit risk, because the government is not going to default on the loan it takes in the form of debt instruments. This makes gilt funds ideal for risk-averse fixed income investors.

Monthly Income Plans

Monthly income plans are debt oriented hybrid mutual funds. These funds invest 75 – 80% of their portfolio in fixed income securities and the 20 – 25% in equities. The equity portion of the portfolio of Monthly Income Plans provides a kicker to the generally stable returns generated by the debt portion of the portfolio. Monthly income plans can generate higher returns from pure debt funds. However, the risk is also slightly higher in monthly income plans compared to most of the other debt fund categories.

Credit opportunities funds

These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds do not invest according to the maturities of debt instruments. These funds try to earn higher returns by taking a call on credit risks. These funds try to hold lower-rated bonds that come with higher interest rates and are, therefore, relatively riskier debt funds. The average maturities of the bonds in the portfolio of credit opportunities funds are in the range of 2 – 3 years. The fund managers hold the bonds to maturity and so there is very little interest rate risk.

Fixed maturity plans

Fixed Maturity Plans (FMPs) are close ended schemes. In other words, investors can subscribe to this scheme only during the offer period. The tenure of the scheme is fixed. FMPs invest in fixed income securities of maturities matching with the tenure of the scheme. This is done to reduce or prevent re-investment risk. Since the bonds in the FMP portfolio are held till maturity, the returns of FMPs are very stable. All FMPs have a fixed horizon for which your money will be locked-in. This horizon can be in months or years. An FMP is like a fixed deposit that can deliver superior, tax-efficient returns but do not guarantee returns. FMPs are suitable for investors with low risk tolerance, looking for stable returns and tax advantage over an investment period of 3 years or more.

Myths about Debt Funds

Debt Mutual Funds are SAFE

It is the misconception among many of us that Debt Mutual Funds are safe and we treat these products like Bank FDs or PPF. But in reality, you check the debt fund categories and notice how the modified duration and average maturity change from Ultra Short Term Debt Fund to Long Term Gilt Fund or Credit Opportunities Funds. Along with interest rate volatility, the risk of credit rate downgrade or default is always there.

We must match our goal with average maturity of the fund

This is one more myth because the experts who recommend it feel debt funds are SAFE. However, these funds also carry the variety of risks. Hence, if your goal is 5 years, then the average maturity must be around 1-2 years of a fund. This is because if the NAV falls due to any risk involved in the fund it may get time to bounce back.

Timing the interest rate movements

It is hard for common man to track the interest rate movements and investing based on the call. Hence, never do such things. Instead, the priority should be to reach your financial goal safely.

Credit Rating is constant

Few believe that if currently the bond instrument is rated as AAA, it will remain same forever. It is not like that. Based on the financial health of the bond, the rating may change. Hence, never be in wrong belief that ratings are constant.

How do interest rates affect Debt Funds?

Interest rates that we often hear about in the news are the repo rate and reverse repo rates that are decided by the Reserve Bank of India (RBI). The RBI will lend money to commercial banks at the repo rate. There are a lot of factors that result in the increase or decrease of interest rates, but the prevailing interest rates also determine the rate at which institutions issue bonds and other debt securities. The prices of fixed income securities are inversely proportional to interest rates. With an increase in interest rates, bond yields go down and vice versa. This is why debt funds tend to earn higher returns when interest rates fall or are expected to fall, as the prices of bonds will go up.

How do Debt Funds generate income?

First, it is important to dispel a common misconception with debts funds — that they cannot erode in value, just like fixed deposits. While debt funds are not as risky as equity funds, a part of your initial investment can erode, nonetheless. This is because these funds invest in various fixed income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments. The NAV on the debt fund can thus rise or fall along with the underlying bond prices. And what impacts bond prices? For one, interest rate movements in the economy can impact bond prices. If interest rates move up, bond prices fall and vice versa. This is where the concept of ‘duration’ comes into play. As longer-duration bonds are more sensitive to interest rates, the fund manager of a debt fund will increase duration to cash in on the rally in bonds in a falling rate scenario. Debt funds can also incur losses if they make wrong credit calls. Some debt funds capitalise on interest receipts. Thus they invest in bonds with lower credit ratings, betting on the credit risk to earn higher interest. So, how can these funds suffer losses? If the company that has issued the bond defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off. This will impact the NAV of the debt fund. Hence, debt funds can follow a strict ‘duration’ or ‘credit’ call or blend the two to come out with different strategies.

For conservative investors

For those looking for alternatives to bank savings and fixed deposits, liquid funds and ultra short-term debt funds fit the bill. While these funds are riskier than bank FDs, they carry the lowest risk amongst debt funds. Liquid funds are the safest in the category and have, on an average, delivered 7-9% returns annually over the last five years. Compared to liquid funds, ultra short-term debt funds carry slightly higher risk, given that these funds invest in debt securities with residual maturity of up to one year. The returns, though, can be higher. Over the past five years, returns from this category have averaged 7.5-9.5%. For investors looking at debt funds for a period of less than three years, their returns will be taxed at the income tax slab rates. Interest on savings accounts is exempt up to ₹10,000 under Section 80TTA of the Income Tax Act. But even assuming 7% return on liquid funds, post-tax returns work out higher than the 4% that most banks offer. In addition, for large sums of surplus, liquid or ultra-short term funds still offer better returns. While bank FDs for less than a year may offer returns comparable to those from liquid or ultra-short debt funds, should you need the money before maturity, you will be charged a penalty. Liquid funds allow you to exit investments without such penalties.

For moderate risk-takers

For investors with a slightly higher risk appetite and longer time horizon of, say, 2-3 years, debt funds, which generate returns both from accruals and duration calls (only moderately), may be considered. Short-term income funds and Banking and PSU Debt Funds fall under this category. Short-term income funds invest in debt securities that mature up to 3-4 years. Their portfolios usually have a small allocation to long-term gilts and higher allocation to AAA-rated, medium-tenure, corporate bonds. Banking and PSU Debt Funds offer stable returns and minimise risk by investing in good-quality debt instruments, mainly issued by banks and public sector undertakings.

For high-risk takers

Investors willing to bet aggressively on either credit or interest rate movements can consider credit opportunities funds, regular income funds, dynamic income funds and long-term gilt funds. Credit opportunities funds invest a relatively higher portion in lower-rated bonds. Hence they carry higher credit risk, while duration is maintained at 2-4 years, minimising rate risk. Regular income funds carry higher rate risk but lower credit risk. Dynamic bond funds essentially ride on rate movements and alter the duration of the fund portfolio depending on the expectation of rate movements. Gilt funds carry negligible credit risk. But as they carry a relatively higher duration of 7-10 years, they are more prone to rate risk. They can generate returns of 16-18% in favourable markets but can also hurt when rates surge.

The risks of Debt Funds

Debt funds generate returns from two sources. The first, which is simpler to understand, is by accruing coupon pay outs on a periodic basis from their underlying securities. The second, which is more complex, is by way of generating ‘capital gains’ on the same securities. Intuitively, it follows that coupon pay outs are exposed to the risk of the borrower defaulting, or credit risk. Credit risk relates to the ability of an issuer to pay the interest and principal during the life of a particular bond. If the issuer is not able to service the interest or principal, it can lead to loss of capital; this scenario is called credit default.

It rings true that there are no ‘free lunches’ in the investment world, and debt fund investors rubbing their hands in glee at their funds possessing higher yields-to-maturity, must also bear in mind that this potential excess return comes at the cost of increased risk. Investors should be aware that if a debt fund is giving a higher yield vis-à-vis other similar products, it is likely to carry a higher credit risk, and hence, lower safety.

In pursuit of capital gains, the fund manager primarily employs two strategies. The first one involves benefiting from falling interest rates by holding higher maturity bonds, whose prices fluctuate more sharply in inverse correlation with rate changes. Interest rate risk is higher for funds with higher average maturities. Hence, the risk is lowest for liquid funds, and rises as the average maturity of the fund increases. Alternatively, fund managers can elect to take on a deliberate credit risk by buying lower rated bonds, in the well-researched hope that they will undergo a positive ratings transition in the times to come. If the bet pays off, their yields would fall, resulting in capital gains.

The poor understanding that retail investors (defined by AMFI as those who have invested less than Rs 5 lakh in mutual funds) have of debt funds is underscored by the 54% spike in GILT fund ownership this year compared to previous financial year. GILT funds are widely perceived as risk-free as they invest in government-backed securities. But they are extremely sensitive to interest rate changes owing to their high average maturities. According to mutual fund research house Value Research, GILT funds have a category average maturity of 10.97 years as on date, implying that they will likely underperform debt funds with lower maturity portfolios and higher yields, if benchmark yields remain range bound in the near term — a highly likely scenario. In fact, retail investors may balk at the fact that there have been years in which the net asset values (NAV) of these purportedly risk-free GILT funds have fallen more than 15%!

Similarly, investors need to exercise caution while deploying their money in credit opportunity funds that aim to generate alpha by taking on incremental credit risk and investing in lower rated instruments. One needs to carefully weigh his/ her risk appetite for aggressive credit portfolios. A single credit default may have a large impact on returns. Therefore, the credit evaluation and the monitoring process must play a key role in fund selection.

Even liquid funds, commonly perceived as 100% risk free by many individual investors, carry within their portfolios the risk of default. Generally speaking, a liquid fund with a high-quality credit portfolio is very safe in terms of capital safety. In the unfortunate situation of a credit default though, implications could be serious. A recent case in point is the shock faced by investors in Taurus Liquid Fund. They were hit hard by the downgrade of BILT papers that the fund was holding at the time. The impact of the fairly recent Amtek and JSPL downgrades on the debt portfolios of some large asset management companies has also been well chronicled.

Before investing in Debt Mutual Funds you should take care of the following points:

§       Duration

§       Credit Risk

§       Average Maturity

§       Tax

For Debt Mutual Funds Taxation you can have Short Term Capital Gain if holding period is less than 3 years and Long Term Capital Gain if holding period is more than 3 years and the tax rate may vary accordingly.

Who should invest in Debt Funds?

Debt mutual funds are ideal investments for conservative investors. They are good alternatives to fixed deposits. While debt funds deliver returns that are in the range of fixed deposit interest rates, they are more tax-efficient than fixed deposits. The interest income earned from fixed deposits are added to your income and taxed as per the slab you fall under. Short-term gains from debt funds are also added to the investor’s taxable income. But they become tax-efficient when the holding period is 3 years or more. The long-term gains are taxed at 20% after indexation.

Debt funds are also liquid when compared to fixed deposits. While fixed deposits come with a lock-in period, debt funds can be redeemed any time. Partial redemptions can also be done from debt funds.

It is for these reasons that debt funds are recommended in place of fixed deposits. However, one point to keep in mind is that unlike fixed deposits, debt funds do not guarantee capital protection or fixed returns.

Pointers for first time Debt Fund investors

If, like many others, you are planning to migrate from the safe haven of fixed deposits to debt mutual funds this year, you might want to start off by investing in relatively lower risk, short-term debt or ultra-short-term debt funds with high-credit rating portfolios at first; even at the cost of potentially lower returns. Over time, you could gradually build a more inclusive portfolio comprising funds with lower credit profiles or higher durations that have the potential to deliver 100-200 basis points higher annualised returns than their shorter-term, highly-rated counterparts. Overall, it is best to follow an asset allocation strategy across various debt fund classes to diversify debt investment portfolios. Whatever you decide, it is imperative that you educate yourself on the nuances of debt fund investing before you jump in with both feet.