FUND FLAVOUR

December 2019

Debt Funds…

Debt mutual funds invest a major portion or the entire corpus in debt instruments to earn fixed income and a small portion in money market instruments to maintain liquidity. Examples of debt instruments include government securities, corporate bonds, and debentures. The money market instruments are treasury bills, commercial papers, and certificates of deposits. The prime objective of debt mutual funds is to generate a regular fixed income stream and grow corpus through stable and steady appreciation of fund. This makes it suitable for risk-averse investors who have a 1-5 year investment horizon. Investing in a debt fund means that the investor is looking for stability over returns as that is what is more important for short term financial goals. The returns from debt funds are lower than the equity funds but higher than bank fixed deposits.

 

The modus operandi...

Debt funds aim to generate returns for investors by investing their money in avenues like bonds and other fixed-income securities. This means that these funds buy the bonds and earn interest income on the money. The yields that mutual fund investors receive are based on this. This is similar to how a Fixed Deposit (FD) works. When you deposit in your bank, you are technically lending money to the bank. In return, the bank offers interest income on the money lent. However, there are many more nuances to debt fund investments. For example, a particular debt fund can buy only specific securities of specific maturity ranges - a gilt fund can buy only government bonds while a liquid fund can buy securities of maturity up to 91 days. Debt funds also do not offer assured returns but have market linked returns which can fluctuate. Rising interest rates can have a positive impact on yields / interest income but a negative impact on bond prices. The reverse is true when interest rates fall.

The types...

1.      Income Funds: 

Income funds are a type of debt mutual fund that attempts to provide a stable rate of returns in all market scenarios through active portfolio management. While it is a debt fund, income funds also run the risk of generating negative returns as many scenarios could play out - such as - interest rates may drop drastically, resulting in a drop of the underlying bond prices. It is even possible that the active fund manager could pick lower-rated instruments that could offer potentially higher returns.

2.      Dynamic Bond Funds: 

Through active and ‘dynamic’ portfolio management, dynamic bond funds seek to maximize the returns to investors by switching up the investment portfolio depending on market conditions and fluctuations.

3.      Liquid Funds: 

The entire point of investing in a liquid fund is to maintain a high degree of liquidity (i.e. convertibility to cash/cash value) in the investment. Securities and instruments that are invested in by liquid fund schemes have a maximum maturity period of 91 days. Usually, only very highly-rated instruments are invested in, through liquid funds. The benefit of these funds is primarily felt by those investors who have surplus funds to park in an income generating investment. The reason these are preferred is that they give higher returns than savings accounts and attempt to provide a similar level of liquidity.

4.      Credit Opportunities Funds: 

These funds are the riskier type of debt mutual funds. They undertake calculated risks like investing in lower-rated instruments to generate potentially higher returns. Anticipating a rise in ratings of papers through market analysis, credit opportunities fund managers invest in instruments rated under even “AA”, in the hope that they will rise to become higher-rated over time, and thus, increase in value.

5.      Short-Term and Ultra Short-Term Debt Funds: 

These fund schemes are popular among new investors who want a short term investment with minimal risk exposure. The securities, instruments, papers, etc. that are invested in by these schemes have a maximum maturity of 3 years and usually a minimum maturity of 1 year.

6.      Gilt Funds: 

These schemes invest primarily in government-issued securities which carry a very low level of risk and are generally rated quite high (as the default rate is very low and sometimes non-existent). What these schemes lack in risk-taking ability, they more than make up for, in security.

7.      Fixed Maturity Plans: 

Fixed maturity plans can be closely likened to fixed deposits. These schemes have a mandatory lock-in period that varies depending on the scheme chosen. The investment must be done once, during the initial offer period, after which further investments cannot be made in this scheme. The way in which it differs from FDs is that the returns are not guaranteed, but if they do generate positive returns, they will be most likely higher than any bank FD scheme.

The benefits…

1.      Stable income

Debt Funds have potential to offer capital appreciation over a period of time  While debt funds come with a lower degree of risk than equity funds, the returns are not guaranteed and subject to market risks.

2.      Tax efficiency

Many people invest money for the prime reason of reducing their annual tax outgo. So, if tax reduction is a crucial investment goal, you can consider investing in debt mutual funds. This is because debt funds are more tax-efficient than traditional investment options like fixed deposits (FDs).

In FDs, the interest you earn on your investments is taxed each year based on the income slab for which you are eligible irrespective of the maturity date being in that year or later. In case of debt funds, you pay tax only in the year you redeem and not before that. You also pay tax only on the redemption proceeds, even if it is a partial redemption. You pay Short Term Capital Gains (STCG) tax if you hold your mutual fund units for less than three years and Long-Term Capital Gains (LTCG) for investments beyond three years. LTCG are eligible for indexation benefits wherein you are taxed only on the returns which are over and above the inflation rate (embedded in cost inflation index {CII}). This helps to reduce your tax outgo as well as provides better post tax returns.

3.      High liquidity

Fixed deposits come with a specified lock-in period. If you liquidate your FD prematurely, the lender may charge you a penalty. While debt mutual funds have no lock-in periods, some of the funds carry an exit load which is a charge deducted at source for early withdrawals. The exit load period varies from fund to fund while some funds have nil exit load as well. However, debt mutual funds are liquid and you can withdraw your money from the fund on any business day.

4.      Stability

Investing in debt funds can also increase the balance of your portfolio. Equity funds (while offering higher return potential) can be volatile. This is because the returns on equity funds are linked directly to the performance of the stock market. By investing in debt funds, you can adequately diversify your portfolio and bring down overall risk (cushion the downside)

5.      Flexibility

Debt mutual funds also offer you the option of moving around your money to different funds. This is possible through a Systematic Transfer Plan (STP). Here, you have the option to invest a lump sum amount in debt funds and systematically transfer a small portion of the fund into equity at regular intervals. This way you can spread out the risk of equities over a specified period of a few months rather than investing the entire amount at one point. Other traditional investment options do not offer this degree of flexibility to investors.

The choice…

There are various debt funds to choose from. Selecting the right fund from different options can get complicated. So, here are a few factors to consider before you select a fund.

a. Fund Objectives

Debt funds aim at optimising returns by diversifying the portfolio of various types of securities. You can expect them to perform predictably. It is because of this reason that debt funds are accessible among conservative investors.

b. Fund Category

Debt funds are further classified under various categories such as liquid funds, monthly income plans (MIPs), fixed maturity plans (FMPs), dynamic bond funds, income funds, credit opportunities funds, GILT funds, short-term funds, and ultra short-term funds.

c. Risks

Debt funds are subject to interest rate risk, credit risk, and liquidity risk. The fund value may fluctuate due to the movement in the overall interest rates. There is a risk of default in the payment of interest and principal by the issuer. Liquidity risk is seen when the fund manager is not able to sell the underlying security due to lack of demand.

d. Cost

Debt funds charge an expense ratio to manage your investment. No fund house can charge above the limit set by the Securities and Exchange Board of India (SEBI).

e. Investment Horizon

An investment horizon of three months to one year is ideal for liquid funds. If you have a longer horizon of say two to three years, then you can explore short-term bond funds.

f. Financial Goals

Debt funds can be used to achieve a variety of goals such as earning additional income or for liquidity.

g. Market Outlook

The market outlook matters a lot. If inflation is likely to risk, then bond yields could risk too and that means your long term bond funds will see capital erosion. When inflation goes down, the reverse order works and you get capital appreciation on long dated funds. Position yourself accordingly.

h. Duration of the Fund

Duration of the fund also matters, especially if you are matching your debt funds with payables arising after time. For example, if you have a committed outstanding in 5 years from now, then you need to select a debt fund with an average duration of 5 years so as to minimize your interest rate risk.

i. Pedigree of the Fund

Style, pedigree and performance of the fund also matter. When you want stable returns do not go for dynamic funds with asset allocation discretion. Fund houses with pedigree generally avoid risky debt instruments. Focus on the past performance and benchmark to an index. Give more importance to consistency than to the CAGR returns.

The Evaluation…

a. Fund Returns

You need to look for consistent returns over long-term say three, five, or ten years. Choose funds that have outperformed the benchmark and peer funds consistently across different time frames. However, remember to analyse the fund performance, which matches your investment horizon to get results.

b. Fund History

Choose fund houses that have a strong history of consistent performance in the investment domain. Ensure that they have a consistent track record of at least say five to ten years.

c. Expense Ratio

It shows how much of your investment goes towards managing the fund. A lower expense ratio translates into a higher take-home return. Choose a fund which has a lower expense ratio and has the potential to give you superior performance.

d. Financial Ratios

You can use financial ratios such as standard deviation, Sharpe ratio, alpha, and beta, to analyse a fund. A fund having, higher standard deviation, and beta are riskier than a fund with lower beta and standard deviation. Look for funds with a higher Sharpe ratio, which means it gives higher returns on every additional unit of risk being taken.

The Performance…

The potential of debt funds to give higher returns than FDs remains intact. The one year return of Ultra Short Duration Debt Funds, Short Duration Debt Funds and Medium Duration Debt Funds are 7.18%, 5.82% and 5.97% respectively. The one-year average return on liquid funds (one of the lowest-risk debt fund categories) is 6.99%, for three years it is 6.79% and for five years, 7.42%. In comparison, the one-year FD rate State Bank of India Ltd offers is 7% and the three-year rate is 6.75%.

 

The steps…

Over the past few years, investing in debt funds in India has become effortless. Here are the steps to begin your investment journey in debt funds:

1.                  Identify the debt mutual fund you wish to invest. You can base this on factors like the past performance of the fund, charges involved, pedigree of the Asset Management Company (AMC), performance track record / experience of the fund manager, etc.

2.      Create an account with the AMC. These days, most funds allow investors to complete this step online.

3.      Submit your KYC documents (if you have not already done so)

4.      Specify the amount you wish to invest and the frequency of investment

5.      Invest the amount on the selected dates and relax. You can also give online instructions to your bank to transfer the required amount into the fund on the specified date each month.

6.      Monitor the performance of the fund regularly. If the fund’s performance is not up to the mark, you can shift your investment to another fund.

The Target Personnel…

You may want to invest in debt funds if:

1.      You have surplus funds to park for a while, and do not mind taking a small bit of risk for the possibility of returns higher than a savings bank account or a fixed deposit.

2.      You are not willing to place your money at as much risk as an equity fund.

3.      You prefer the possibility of small but stable returns over the possibility of large capital appreciation.

4.      You are unhappy with the current rate of returns provided by your savings bank account.

5.      You wish to earn higher returns than an average fixed deposit scheme.

6.      You wish to supplement your current income - i.e. if your current salary is not able to meet the demands of your lifestyle, you could invest in a debt mutual fund scheme to add a certain amount of “income” (in the form of returns) each month.

 

Risk-averse investors generally choose to invest in debt fund schemes. Investors who are happy with the possibility of a low, but regular rate of returns versus high-risk exposure capital appreciation equity funds choose debt fund schemes.