Monday, September 07, 2020

 

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.

 Liquidity Risk: This type of risk is of the fund house and happens when it does not have adequate liquidity to meet the current redemption requests.

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

Given the current context, investors should stay invested only in AAA rated instruments. Investors should invest in top quality instruments in the debt market such as government of India bonds, AAA rated blue-chip companies and PSU bonds to preserve their capital. In the current economic scenario, following the above strategy will definitely lower volatility in their portfolio. Further, investors should choose funds with a portfolio duration that is longer than their investment horizon in the current timings of interest rate easing. This will help to manage the interest rate decline in favour of return on risk-return matrix. Further, they should stay invested in highly rated short-term funds with a holding period of two to three years. If your holding period is less than one year, it is better to look at instruments in the money market rather than the debt market. Investors must understand that the current investment landscape is novel coronavirus induced and as of now the prudent move is to preserve and protect their capital instead of focusing on returns.

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