Debt Mutual Funds in India

What is a Debt Fund?

Debt mutual funds invest in securities that generate fixed income, like corporate bonds, treasury bills, government securities, commercial papers, and many other money market instruments. As a buyer, you can earn a pre-decided fixed interest rate on the maturity of these instruments. Market fluctuation does not affect investors’ returns. For this reason, debt funds fall under low-risk investment options.

What are the benefits of investing in a debt mutual fund?

Debt funds have many advantages, some of them are:

Stable Growth of Investment

Debt mutual funds invest in fixed-income securities and capitalize on the steady income from these securities for growth. The fixed income securities offer regular interest and capital appreciation based on market conditions. Due to the regular and primarily steady stream of inflows, debt funds offer more stable growth than equity mutual funds.

Better Liquidity Than Other Debt Investments

Unlike other investment options, debt mutual fund schemes, especially liquid funds, have high liquidity. They are also considered an alternative to fixed deposits because they are low-risk and have no mandatory lock-in period. Unlike fixed deposits, debt mutual funds do not have a long withdrawal time.

More Tax Efficient Than Traditional Investments

Investing in a debt mutual fund for at least three years becomes far more tax-efficient than other debt investments like fixed deposits and bonds. The short-term gain occurs if the investment is liquidated (= withdrawn) within three years. Liquidation any time after three years or 36 months will generate a long-term capital gain.

Taxability of Income from Debt Mutual Funds

No TDS: Another benefit is that TDS does not affect debt schemes, unlike fixed deposit, which has a straight deduction of 10.3%.

Transfer Funds to Other Schemes

If you have invested in a debt fund scheme, you can transfer the money to an equity scheme or any other scheme hassle-free. Such an option is unavailable to you in different investment schemes like fixed deposits.

What are the different types of debt funds?

Debt funds can be classified into the following different types based on the maturity period:

Liquidity here only refers to the possibility of withdrawing your investment from the fund without incurring charges. Funds with low liquidity may discourage early withdrawals and apply additional charges.

How do Debt Mutual Funds Work?

Like any mutual fund, debt funds collect money from thousands of investors and allocate units to them at NAV. (See more in “How Does Mutual Fund Work?”)

The only difference from other mutual funds is that debt funds use the collected money (Asset Under Management) to buy debt securities from the secondary debt market. This market segment is called the Wholesale Debt Market, and in India, it is heavily dominated by Government securities.

Debt funds may invest in fixed-income securities slightly differently depending on the structure of the scheme:

Fixed Maturity Plans

FMPs, or Fixed-Maturity Plans, have a fixed maturity period, ranging from 3 to 5 years and sometimes even longer. Based on the tenure of the FMP, the fund manager invests in debt securities so that all the instruments mature around the same time as the FMP. Thus, FMPs are somewhat immune to interest rate risk and won’t trade in their securities. However, long-duration FMPs may also miss opportunities.

Unlike open-ended debt funds, FMPs will only accept investors within particular subscription dates and lock in the money until maturity. Thus, FMPs are less liquid as well. You may only sell the units back to the fund house if you need an emergency exit.

Open-Ended Debt Funds

The open-ended scheme allows you to enter and exit at any time. Open-ended funds are also very active in trading debt securities and try to maximize their earnings by riding the capital gain wave as the interest receipts.

The returns are generated in the following two forms (similar incomes but influenced by different reasons):

1. Coupon or Interest receipts
2. Capital Appreciation

Coupon & Interest Receipts

All bonds and debt securities, except ‘zero-coupon bonds,’ pay a fixed interest on a regular interval. Liquid and ultra-short-term debt funds may be an exception to this growth formula. For details, see: “How Does Liquid Mutual Fund Work?”

For example, a bond you can buy at Rs. 931 today (face value Rs. 1000) may pay a quarterly interest based on its coupon rate. So, if the coupon rate on the bond is 5%, payable quarterly, you will receive Rs. 12.5 for every such bond you have invested in.

So, regular coupons are one way to earn from bonds and fixed-income securities. Another way is capital appreciation.

Capital Gain in Bonds

A bond’s market value may increase for several reasons. But it only happens before maturity.

As the bond’s maturity approaches, its market value inches closer to its face value. The market value of the bond may vary based on the following factors:

• The prevailing interest rate in the market
• Issuing firm growing on the credit rating scale
• Demand for the bond rising due to any other factor

While theoretically, as the RBI plays with the repo rates and reverse repo rates, bonds may see a variation in their market value. The logic behind this shakeup is called ‘opportunity cost.’

Imagine you hold a bond that promises to pay a coupon of 10% p.a. for the next five years. The next day, RBI reduced the repo rate, and now the new investors can only get about 8% p.a. on their investments. Naturally, your bonds are more valuable now since they pay a higher interest rate.

Debt fund managers can take advantage of this situation on the bonds they hold and liquidate them to cash in the capital gain.

Are debt mutual funds risk-free?

Debt funds are not risk-free, but they are a much safer option than equity funds. As mentioned above, the return on debt securities may vary due to certain factors. It’s a no-brainer that the same factors would affect the funds holding these securities.

Risks in Debt Funds

A debt fund’s typical risks could be the following three types. But, each fund, depending on the kind of security it holds, may carry a different degree of each of these risks:

Credit or Default-Risk

Under this, the issuers of the bonds may not pay the principal and interest. This is the most dangerous of all the risks because ‘a default’ can cause permanent capital loss.

Interest Rate Risk

In a dynamic market, prevailing interest rates an investor can safely earn keep changing. Thus, the prices of bonds and the opportunity cost of holding them could change over time, making them less valuable and dragging the fund’s NAV down.

Liquidity Risk

is the risk carried by the fund house of not having adequate liquidity to fulfill the investor’s redemption request.

How to Evaluate Risk in Debt Funds?

The Fund Managers

When you are looking to invest in debt funds, make sure you are picking a good fund where the fund managers have a clean track record of defaults. Studying fund managers won’t be easy for you, so that you can study the ratings given by credit rating agencies. The top-rated funds are labeled as AAA, then comes slightly lower AA, and it goes on till D.

The NAV Trend

You can check the risk associated with the fund by checking the NAV growth of the last 5 years. If you see stable and uniform growth, you can conclude that no significant credit event affected the fund.

Significant Redemptions

If the fund receives significant redemption, it may have to shut down soon and stop investors from redeeming.

Average Duration of Fund’s Securities

It is recommended that you match the time frame of your investment with the average duration of the securities the fund is holding. If you do so, the interest rate volatility can be evened out, and you can expect a return close to Net YTM (Yield To Maturity).

What Does Fund SID Tell You?

Scheme Information Document or SID tells you what the scheme is about, its objective, what it will do, and how and where it will invest. SID can overload you with its information so that you can focus on the crucial sections in SID.

You would want to focus on the following are the information in the SID:

• Indicative Asset allocation: This gives you the fund’s investment strategy.
• Fund Manager: The SID lists the fund, their co-fund managers, and their past experiences and qualifications.
• Tax Implication: You should check for tax implications on realized profits and dividends.
• Redemption Limit and Minimum Investment: In this section, you should find the scheme’s minimum investment and redemption limit.

How do you choose/evaluate mutual funds for debt?

Below are the parameters you need to consider to evaluate the debt mutual funds:

• Investment Period: You must decide your investment horizons and the period you want to stay invested. The debt funds offer you the option to invest for a day and 10-20 years. You can shortlist the funds you want to invest in based on your investment period. If you have an investment horizon of three years, choosing a fund with lower redemption expenses is always better so that you do not lose earnings during early withdrawals.
• Risk Appetite: The risk varies from fund to fund and investor to investor, so you need to know your risk appetite. Overnight and liquid funds carry the least interest rate risk, whereas a gilt fund has the least credit risk.
• Interest Rate Scenario: Investing in short-duration funds when interest rates are rising is wiser. This is because, with increasing interest rates, the modified duration of long-duration debt funds will be higher.
• Expense Ratio: This is an essential parameter before investing in debt funds. A fund house charges an annual maintenance fee to manage its expenses, such as operating cost allocation charges, management fees, etc. Since the returns in debt funds are not higher, a high expense ratio can dent your earnings. You should always look for schemes with lower expense ratios.

References:

1. Return on Debt Funds – Moneycontrol.com
2. Fund Deployment by Mutual Funds – SEBI Stats
3. Debt Funds Risk & Return – AMFI
4. SEBI Categorization of Mutual Funds – AMFI
5. Working of Debt Mutual Funds – Value Research