FUND FLAVOUR
September 2020
Steady wealth accumulation and capital appreciation
A debt fund is an investment instrument wherein the
capital is invested primarily in fixed-income investments. These are
predominantly treasury bills, government securities, corporate bonds and other
similar money market instruments. Debt funds, alternatively known as
fixed-income funds or credit funds, come under the fixed income asset category
of mutual funds. The main
objective of a debt fund is to accumulate wealth through interest income and
steady appreciation of the capital invested. The underlying assets generate a
fixed rate of interest throughout the tenure for which investors stay invested
in the fund. The fund manager of a debt fund invests in the underlying assets
based on their respective credit ratings.A higher credit rating indicates that
debt security has a higher chance of paying interest regularly along with the
repayment of the principal upon expiry of the investment tenure. However, debt
funds also invest in low-quality debt securities. Fund managers choose
securities based on several other factors too. Sometimes, they choose
low-quality debt securities because those might earn higher returns later. There
is no reason to worry because the best fund manager always takes a calculated
risk. But, debt funds that have high-quality securities in their portfolio are
more stable. Apart from that, the fund manager aligns his investment strategy in
accordance with the overall interest rate movements.
The modalities…
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 upto 91 days. Debt funds 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. You need to match your
investment horizon with the average maturity of your fund securities. Average maturity
is the weighted average of all of the current maturities of the debt securities
your portfolio holds. It gives you an idea about the mean age of every debt
security in your fund portfolio. The higher the average maturity of a debt
fund, the longer it takes for each security to mature and vice-versa. The
average maturity keeps varying and has an important impact on the fund’s
overall returns and risk associated. In a nutshell, longer average maturity is
equivalent to the higher risk associated with the fund and higher volatility
too, and vice versa.
Multifarious Funds…
Debt Funds of various hues are discussed below:
1. Liquid Fund
Liquid Fund is a type of fund that invests in money
market instruments that have a maturity period of 91 days. Liquid Funds,
generally offer better returns (7% to 9%) when compared to bank savings account.
So, these are a good alternative if you want to stay invested in the short
term.
2. Money Market Fund
Money Market Funds invest in money market instruments
that have a maximum maturity period of 1 year. These are good for those
investors who wish to stay invested for the short term and have a low-risk
tolerance.
3. Dynamic Bond Fund
These invest in debt securities with varying maturity
periods as per the interest rate regime. These are good for investors having
moderate risk tolerance and for those who want to stay invested for about 3 to
5 years.
4. Corporate Bond Fund
Corporate Bond Funds invest a minimum of 80% of their
total assets in corporate bonds that have the highest ratings. These are ideal
for investors whose risk tolerance is low but who wish to invest in
comparatively high-quality corporate bonds.
5. Banking and PSU Fund
Banking and PSU Funds, as the name suggests, invest at
least 80% of their portfolios in debt securities of PSUs (Public Sector
Undertakings) and banking institutions.
6. Gilt Fund
These invest at least 65% of their portfolios in government
bonds with high ratings. So, these funds offer best returns of the highest
quality bonds.
7. Credit Risk Fund
Credit Risk Funds invest a minimum of 65% of its
portfolio in corporate bonds that have their ratings below the highest-rated
corporate bonds. So, these funds do have credit risk associated with them but
offer slightly better returns when compared to the highest quality bonds.
8. Floater Fund
These invest a minimum of 65% of its investible corpus
in floating-rate investments. Floater funds have a low interest-rate risk
associated.
9. Overnight Fund
As the name suggests, Overnight Funds invest in debt
securities with a maturity period of 1 day. Such funds are very safe to invest
in as both credit risk and interest rate risk associated with them is minimal
to negligible.
10. Ultra-Short Duration Fund
This fund invests in money market instruments and debt
securities in such a manner that the Macaulay duration of the fund is from 3 to
6 months.
11. Low Duration Fund
Low duration debt funds invest in money market
instruments and debt securities in such a manner that the Macaulay duration of
the fund is from 6 to 12 months.
12. Short Duration Fund
Short-term debt mutual funds invest in debt securities
and other money market instruments in such a manner that the Macaulay duration
of this fund is from 1 to 3 years.
13. Medium Duration Fund
Medium duration funds invest in debt securities and
other money market instruments in such a way that their Macaulay duration
ranges from 3 to 4 years.
14. Medium to Long Duration Fund
This type of fund invests in money market instruments
and debt securities in such a manner that the Macaulay duration of this fund is
from 4 to 7 years.
15. Long Duration Fund
The long term debt funds invest in money market
instruments and debt securities in such a manner that the Macaulay duration is
more than 7 years.
16. Fixed Maurity Plans
Fixed
Maturity Plans or FMPs come with a lock-in period. This period can vary based
on the scheme you choose. You can invest in FMPs only during the initial offer
period. After that, you cannot make further investments in this scheme. Many
investors consider FMPs similar to FDs because both come with a lock-in period.
However, unlike FDs, FMPs do not promise fixed returns. However, FMPs are more
tax efficient than FDs.
17. Income Funds
Income Funds
invest in corporate bonds, government bonds and money market instruments. Due
to exposure to corporate debt, they carry credit risk and hence need to be
monitored regularly. Income funds work best when interest rates have peaked in
the market and are expected to go down.
18. Monthly Income Plans
Monthly
Income Plans (MIPs) are a class of debt funds which also have a small exposure to
equity. This not only adds to the risk but also enhances returns due to equity
exposure. MIP exposure must be for a longer period of time.
The rewards and…
Stability
While debt
funds do carry risk, they tend to be less volatile in terms of value compared
to equity funds.
Diversification:
Debt Funds
also give you the advantage of diversification which is instrumental in
reducing the risk. That is done by spreading your money across a range of
interest bearing instruments like Treasury Bills, Government Securities,
Corporate Bonds, Money Market Instruments etc.
Liquidity:
Debt funds
are highly liquid as you can redeem them at any time; either offline or even
online on the internet. Debt fund redemptions typically get credited to your
bank account the next day so they are as good as near-money. As an investor in
debt funds there are no restrictions on withdrawal. Even closed ended funds are
listed.
Tax Efficiency:
For taxation purposes, all mutual funds with
investments lower than 65% in equity instruments are considered debt funds.
Short-term capital gains of less than 36 months are taxed corresponding to the
investor’s income tax slab. A tax rate of 20% is levied on long-term capital
gains above 36 months after indexation. Dividends on debt funds are tax-free in
the hands of the investor but are subject to Dividend Distribution Tax (DDT) of
29.12%. A more efficient way is to hold it for more than 3 years so that it
becomes LTCG and is taxed at 20% with benefits of indexation.
Guaranteed or safest returns with debt funds:
Debt funds invest mainly in securities that give fixed
interest returns. Still, there is a remote probability that the debt fund would
not perform as expected. However, this possibility is extremely low and happens
only when the investment has been made in low credit-rated securities, or the
interest rate movement is in the negative range.
You can safely place your idle money in debt funds
Overnight funds or liquid funds also fall under the
debt funds, and these have continuously delivered optimal returns over the
years when the investment made is of short term. These have high liquidity and
are perfectly safe for parking your idle money. In addition, as these have high
liquidity, you can easily redeem the units whenever you want to.
Better returns
Debt funds provide better returns when compared to the
returns provided by the traditional saving methods like Bank Fixed Deposits or
Savings Accounts. Savings Accounts deliver an interest rate of 3% to 5% on an average
but debt funds, especially liquid funds have an average return rate of 7%.
Diversified Portfolio
Try to invest in such a debt fund that has a proper
allocation to various money market instruments and does not focus on only one
debt security.
…risks
Debt funds have 3 types of risks associated with them.
1.
Credit
Risk: This
is the default risk associated with debt funds which involve the issuer not
repaying the principal amount and the associated interest. Credit Rating Agencies like CRISIL and ICRA would look at the financial and past
history of a company and assess its debt repayment capability. And then a
rating is given to show this capability. AAA is the highest rating that shows
that the company is almost certain to pay its debt and therefore has a lower
credit risk. The next is AA, which points towards lower certainty. Hence, it
has a slightly higher credit risk.
Similarly, this rating is up to D. D is given when a company has not repaid its
loan or it seems that it will not be able to repay the loan. The best way to
avoid this kind of risk is that you invest in debt funds that consistently
perform or its rating is AA/ AAA only.
Interest Rate Risk: This is the type of risk that happens due to the effect of changing interest rates on the value of the fund’s securities. Whenever interest rates fall or people think that interest rates are going to fall, high demand increases the bond price. This is understood from an example - suppose a debt fund holds a bond which gives 10% annual interest rate. Now if interest rates fall in the economy, then any new bond coming into the market will give a lower interest rate like 9%. This will increase the demand for old bonds which are paying higher interest rates. Due to this, price of the bond and NAV of the debt fund holding it also increases and vice versa.
Appraisal and…
The following points will help you in choosing the top
debt funds in India:
1. Investment Goal:
If your investment objective is set clear in your
mind, then you will be able to narrow down the debt fund categories
accordingly. Your investment objective could be anything like parking surplus
money, finding a better alternative to bank FDs, a short-term goal, generating
a secondary income source, etc.
2. Investment horizon
Make sure to check the investment horizon while
shortlisting debt funds. This will help you in minimizing the interest risk
rate.
3. Credit Quality
Stick to debt mutual fund schemes with high credit
quality papers and high ratings. This way the credit risk associated with your
debt fund will be decreased.
4. Fund Size
If you want to decrease the concentration risk
associated with your debt fund, then ensure that you invest in a fund with a
large AUM. Besides, this will also protect you from redemption pressures. The
top debt mutual funds come from fund houses having huge fund sizes.
5. Expense Ratio
Pick a fund with a relatively lower expense ratio.
That ensures better returns.
6. History of debt fund
You can compare past performances of the funds. But,
keep in mind that past performance might not be repeated in the future. The
best performing debt funds change every year.
7. Risk appetite
Debt funds do have some risk associated and are not
entirely risk-free. So, analyze the debt fund’s performance and portfolio
allocation properly to get to know about the risk associated with it.
8. Exit Load
Some debt funds do charge an exit load to discourage
premature withdrawal from the fund. Take this point into consideration and try
to pick a fund with zero exit load.
…appeal
Debt funds can
appeal to different classes of investors; both retail and institutional. Let us
look at some of the classes of investors who should be investing in debt funds.
·
Individual investors must invest in debt funds as part of
their financial plan. The financial plan lays out goals in terms of their size
and maturity and debt funds add stability and regular income to your financial
plan.
·
Investors looking to pay short term assured outflows over
the next 2-3 years can also look at investing in debt funds. For example, if
you need to pay home loan margin after 3 years or your daughter’s admission
fees after 2 years then debt funds would be the best.
·
For retired investors seeking regular income in a
predictable manner, debt funds can be very useful. Normally, debt funds do not
run the risk of volatility to the extent of equities and hence most retired
pensioners must look at debt funds for regular income as returns are also
higher than bank deposits.
·
Corporates can park their temporary surpluses of the
business in a debt fund instead of a bank. The debt funds pay a higher yield
compared to the bank deposits and thus it puts idle money to much better use.
·
High Net worth investors (HNIs) and traders can also look
to invest in debt funds as a means of capitalizing on key macro shifts. For
example, an aggressive investor can buy long duration gilt funds when rates are
expected to go down in the market. Similarly, if the view is of a rise in
interest rates, then traders can look to investing in floaters.
·
Debt funds can be a good way of parking idle funds
profitably, when you are waiting for good opportunities to invest in equities.
Every crisis leaves its mark…
The
credit crisis which engulfed debt funds over the past two years, starting
with ILFS Group default, has been exacerbated by the black swan event of
COVID-related lockdown in several parts of the country over the past few
months. A very positive outcome of this crisis has been several significant
regulatory changes for debt funds – be it on investment or valuation or market
related. Investors should be aware of these tighter, clearer and safer norms
and take these additional points into consideration before investing.
Segregation: One
of the key distress points for investors was that when a steep credit event
happened and there was a significant valuation hit, the funds did not have an
option to provide exit to investors while ensuring they do not miss out on
recovery. SEBI guidelines now enable funds to provide segregation as an option.
If this option is enabled on the debt fund you invest in, then the AMC may
decide to segregate the downgraded exposure from the rest of the portfolio. In
such an eventuality, you can exit from the balance exposure while continuing to
have a claim (ownership) on the segregated units and any future recovery would
accrue to you as an investor at the time of the event. The condition is the
downgrade should be to below investment grade or default. So, do check if the
debt fund you invest in has an option for segregation.
Safety
of liquid funds: There have been significant changes to investment
guidelines around liquid funds. These funds now need to mandatorily hold 20% of
their assets as liquid assets defined as cash and cash equivalents and
government securities like T bills. Liquid funds also need to have a graded
exit load up to 7 days. The load is uniform across all mutual funds. This has
reduced a lot of hot/volatile money coming into these funds for very short
period like one or two days.
Change
in valuation guidelines and the haircut matrix: Earlier there was no
uniformity on valuation norms for any default or downgraded (below investment
grade) debt security. AMCs had to ensure fair valuation which could be
interpreted differently by different AMCs. Now AMFI has prescribed a standard
haircut matrix which is followed by the valuation agencies and has made the
valuation more predictable. Investors and their advisors can now understand the
valuation impact better. However, AMCs still can do their own fair valuation if
they disagree with this valuation. The Valuation policy of every AMC is
mandatorily uploaded and available on their website. This can be reviewed if
required.
Detailed
disclosures of portfolio: A recent SEBI guideline now makes it
mandatory for mutual funds to declare their full debt portfolio on a
fortnightly basis on their website versus earlier requirement of monthly basis.
This gives more clarity on how funds manage their portfolios intra-month. Not
only this, now AMCs will have to declare the yield at which each security in
the portfolio is valued. Earlier, only Portfolio Yield (also called YTM) was
declared. This gives more information security wise and helps in attribution
(understanding how the fund is generating their returns).
Tighter
investment norms: These include tighter sector limits, restriction on
investment in unlisted commercial paper or corporate debt and tight limits of
investment in structured and credit enhanced debt. A minimum criterion has been
prescribed for equity share cover for LAS (Loan Against Share) NCD structures
at four times.
Daily
disclosure of transactions: The
Securities and Exchange Board of India's revised disclosure requirements for
debt mutual funds will increase transparency and help investors to take better
exit calls. The move will offer investors a real time understanding of
the portfolio. The new regulation will be
effective from October 1, 2020. The regulator has asked mutual funds to
disclose details of debt and money market securities transacted in their
schemes’ portfolio, including inter-scheme transfers, on a daily basis with a
time lag of 15 days in a prescribed format. "Many schemes have lower grade
or quality securities between second or third day of the month till 28-30th day
and always have a cleaner portfolio during month beginning and end. For
slightly higher return, clients are taking risk without being aware of quality
of the portfolio because at the time of disclosure, the portfolios are clean.
This new rule will make things tight and transparent"
All
these norms are expected to make debt funds less risky.
Every
crisis leaves its mark. Investors should continue to invest in debt funds in
order to meet their financial goals in accordance with their risk appetite.
Prudent move - need of the hour
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