What are Debt Mutual Funds?

 

Debt funds are funds that invest in government securities and corporate bonds. Think of it like an FD. When you open a fixed deposit in a bank, you are essentially giving a loan to the bank and the bank in turn is paying you interest. Similarly, in case of debt funds, the fund manager is investing in govt. securities & corporate bonds who in turn pay them interest.

 

Types of Debt Mutual Funds

 

Debt funds are broadly classified as long duration, medium term, short term, ultra-short term and overnight funds depending upon the maturity of the instruments they are investing in. Some debt funds are also classified basis the quality of paper they invest in. For Eg. Credit risk fund invests in bonds/instruments having credit rating lower than AAA. The fund manager basically takes an informed call to invest in lower rated securities with an expectation to earn better returns.

 

Suitable to which type of Investor?

 

Debt funds invest in fixed income instruments. Though they are largely unaffected by volatilities in the stock market, return from debt funds are not guaranteed. They are ideal for risk averse investors as they are considerably safer than equity funds in terms of returns. Equity funds can give negative or positive returns but returns for debt funds are generally positive although they may vary from year to year.

 

Risk Involved

 

We need to understand the 3 major types of risks that the debt fund is vulnerable to. Let’s study them one by one.

 

1. Credit Risk

 

Credit Risk is the risk of default of interest and or principal repayment on part of the companies/institutions in which the fund manager has invested your money. Credit risk can be gauged on the basis of independent ratings issued by CRISIL, ICRA etc to the instrument. The quality of papers invested in can be seen from the ratings mentioned in the scheme information document/fact sheet. All fund factsheets depict an average credit rating, they also state the percentage of investment made in each of the credit benchmark. Further, one must remember that longer duration debt funds will have higher credit risk than ones with short duration. As a rule of thumb conservative/moderate investors should stay away from funds that invest in securities with AA- and lower ratings.

 

2. Interest Rate Risk

 

Interest Rate Risk means the impact of changes in interest rates on the price of the bond or the instrument that the scheme is invested in. Firstly we
need to keep in mind that interest rates and price of the bonds have an inverse relationship. As interest rates rise the price of the bonds fall and vice versa. Now why is that so? Let’s take an example:

 

Consider a 10% Bond (BOND A) which is currently trading at Rs 100. Now consider another new 8.5% bond (BOND B) is issued in the market. Now, from the investors point of view BOND A looks more attractive due to its higher interest or coupon rate which drives up its price and it now starts trading at a premium of say Rs 110. Other way around, if the new bond issue in the market was at 11%, BOND A no longer looks attractive and starts trading at a discount at say Rs 95. Hence the inverse relationship between bond prices & interest rates. 

 

Now that we understand this relationship let us also understand what macro-economic factors can have an impact on interest rates in the economy. Most important factors affecting interest rates are ‘Government Borrowing’ and RBI Policy rates.

 

For example, say crude prices are on the rise – this results in inflation which in turn results in increased government borrowing ultimately causing the interest rates to rise.

 

Let’s take another example – the current account deficit increases – govt has to borrow more funds. Demand for funds rises and consequently the interest rate increases.

 

The duration/tenure of the securities invested in also plays a large role in determining the impact of interest changes on the NAV of the fund. While investing in debt funds, one should keep in mind that lower the duration of the fund, lower is impact of increasing interest rates or falling prices.

 

3. Concentration Risk

 

Concentration risk is the risk of investing a large part of the fund corpus with a single counterparty. A drill down into the fact sheet can be done to see how much concentration risk is taken by the fund manager. Generally, a funds manager would not invest more than 5% of the fund value in any one security.

 

To summarize, the risk that we need to be aware of before investing in any debt fund

Interest Rate Risk – Impact of changes in interest rates on bond prices 

Credit Risk – Risk of default of repayment of interest and or principal by the instrument issuer

Concentration Risk – Risk of too much investment in single issuer.

 

Taxation efficiency

 

In the long term, (more than 3 years) investment in debt funds tends to be more efficient than parking funds in a bank fixed deposit. While interest on bank fixed deposits is taxed at the slab rate, LTCG on debt mutual funds will be taxed at 20% with indexation benefit.

 

Why are they better than fixed deposits?

 

Apart from the taxation aspect as mentioned above, debt funds score better than fixed deposits in the returns department. Historically debt funds have given additional returns of around 1.5% To 2.5% over and above the fixed deposit rates per annum.

 

Keeping all this in mind, let’s begin our investment journey. Reach out to us at info@investopert.com | Call/WhatsApp us at  9321286864 to invest in various Debt & other Mutual Funds.

 

Happy Investing…

Team Investopert