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Demystifying debt mutual funds

Aug 26, 2015 by Dwaipayan Bose | 281 Downloaded
Picture courtesy - PIXABAY

While there is growing awareness of equity mutual funds among retail investors in India, awareness of debt mutual funds among retail investors is unfortunately still very low. There are also several misconceptions regarding debt funds. Some common misconceptions are:-

  • Bank Fixed Deposits always give better returns than debt funds

  • Debt funds are very risky

  • Debt funds are only for retired people

  • All debt funds are the same

The reality is that none of the above is true. There is a large basket of debt fund offerings in the market, which can cater to a large spectrum of risk profiles, investment horizons, incomes and capital growth needs. In this article, we will discuss different types of debt funds, their risk return characteristics and the investment objectives that these different funds categories address.

Before we go into different types of debt funds, it is important to understand how debt funds generate returns. Since debt funds invest in fixed income securities, they employ two different kinds of investment strategy:-

  • Hold till Maturity: This is also known as accrual strategy, by which the fund invests in certain types of fixed income securities (or bonds) and hold them till maturity of the bond, earning the interest offered by the bond over the maturity period.

  • Duration Calls: Using this strategy the fund manager, takes a view on the trajectory of interest rates. Bond prices go up when interest rate falls and declines when interest rate goes up. Typically, the fund manager taking duration calls will invest in long term bonds because the longer the maturity, higher is the change in bond prices with change in interest rates.

We will discuss the quantitative aspects of these two concepts in more details in another article, but for the purpose of this discussion that the objective of hold to maturity is to generate income, whereas the objective of duration calls is capital appreciation. Let us now discuss the different types of debt funds. While there might be several sub-categories, there are broadly six types of pure debt funds.

Gilt Funds

Gilt funds invest in Government securities with varying maturities. Average maturities of government bonds in the portfolio of long term gilt funds are in the range of 15 to 30 years. The fund manager in long term gilt funds actively manage their portfolio and take duration calls with outlook on the interest rate. The returns of these funds are highly sensitive to interest rates movements. For example, if interest rate falls by 1% in a year, these funds can give 15 – 16% returns. If interest rates fall more, then the returns are higher. On the other hand, if interest rate rises then returns are low. Some investors mistakenly believe that since gilt funds invest in the Government securities these funds are risk free. Actually, it is exactly the opposite, gilt funds are riskiest among all debt fund categories.

Investment Horizon: Investors should have at least a 2 to 3 year investment horizon for investment horizon in gilt funds.

Investment Objective: The NAVs of gilt funds can be extremely volatile.If you have moderate to high risk tolerance level and are looking for capital appreciation, then you can invest in Gilt Funds.

Income Funds

Income funds invest in a variety of fixed income securities such as bonds, debentures and government securities, across different maturity profiles. For example they can invest in 2 to 3 year corporate non convertible debenture and at the same time invest in a 20 year Government bond. Their investment strategy is a mix of both hold to maturity (accrual income) and duration calls. This enables them to earn good returns in different interest rate scenarios. However, the average maturities of securities in the portfolio of income funds are in the range of 7 to 20 years. Therefore, these funds are also highly sensitive to interest rate movements. However, the interest rate sensitivity of income funds is less than gilt funds. If interest rate falls by 1%, income funds can give 12 – 14% returns. On the other hand, if interest rate goes up the returns will be much lower.

Investment Horizon: Investors should have a long investment horizon of at least 3 years for income funds.

Investment Objective: If you have moderate to high risk tolerance level and are looking for both income and capital appreciation in different interest rate scenarios, you can invest in income funds. In a rising interest rate scenario, decline in long term government bond prices will be offset by higher yield from short maturity bonds (NCDs). In a falling interest scenario, lower yield from short maturity bonds will be offset by capital appreciation in long term bonds.

Short Term Debt Funds

Short term bond funds invest in Commercial Papers (CP), Certificate of Deposits (CD) and short maturity bonds. The average maturities of the securities in the portfolio of short term bond funds are in the range of 2 – 3 years. The fund managers employ a predominantly accrual (hold to maturity) strategy for these funds. In the current interest rate scenarios these funds are giving around 9% returns. However, if yields decline then the returns will be lower.

Investment Horizon: Investors should have a one year investment horizon for short term debt funds.

Investment Objective: Short term debt funds are suitable for investors with low risk tolerance, looking for stable returns. Investors should look at the yield to maturity of the fund portfolio to get a sense of expected returns.

Credit Opportunities Funds

Credit opportunities fund are similar to short term debt funds. The fund managers lock in a few percentage points of additional yield by investing in slightly lower rated corporate bonds. Despite the slightly lower credit rating of the bonds in the credit opportunities fund portfolio, credit risk should not be a concern for the investor because the funds invest in papers rated A and higher. In fact, on an average, majority of the bonds in the fund portfolios are rated AAA and AA. The average maturities of the bonds in the portfolio of credit opportunities funds are in the range of 2 – 3 years. The fund managers hold the bonds to maturity and so there is very little interest rate risk. Good credit opportunities funds have given double digit returns in the recent past.

Investment Horizon: Investors should have a one to two year investment horizon for credit opportunities fund.

Investment Objective: Credit Opportunities funds are suitable for investors with low risk tolerance, looking for slightly higher than fixed deposit returns over 1 to 2 years. Like short term debt funds, investors should look at the yield to maturity of the fund portfolio to get a sense of expected returns.

Fixed Maturity Plans

Fixed Maturity Plans (FMPs) are close ended schemes. In other words investors can subscribe to this scheme only during the offer period. The tenure of the scheme is fixed. FMPs invest in fixed income securities of maturities matching with the tenure of the scheme. For example, if the tenure of an FMP is 1100 days, then the fund manager will invest in bonds which will mature in 3 years and hold them to maturity. This is done to reduce or prevent re-investment risk. Since the bonds in the FMP portfolio are held till maturity, there is no interest rate risk. The returns of FMPs are very stable. You can get a sense of FMP returns from the indicative portfolio in the offer document of the FMP (please refer to our article, How to calculate indicative returns from FMP NFOs).

Investment Horizon: Post the change in taxation of debt funds announced last FY 2014 – 15, FMPs have a minimum tenure of three years to avoid short term capital gains tax.

Investment Objective: FMPs are suitable for investors with low risk tolerance, looking for stable returns and tax advantage over an investment period of 3 years or more. They can provide better post tax returns than bank fixed deposits and are attractive investment options when yields are high.

Liquid Funds

Liquid fund are money market mutual funds and invest primarily in money market instruments like treasury bills, certificate of deposits and commercial papers and term deposits, with the objective of providing investors an opportunity to earn returns, without compromising on the liquidity of the investment. Typically they invest in money market securities that have a residual maturity of less than or equal to 91 days. Liquid funds give higher returns than savings bank. Unlike savings bank interest, no tax is deducted at source for liquid fund returns. There is no exit load. Withdrawals from liquid funds are processed within 24 hours on business days. Currently liquid funds are giving on an average around 8% returns.

Investment Horizon: You can park your surplus cash in liquid fund for 3 to 6 months and make withdrawals at any time. If you want to park your cash for a longer period, say 6 to 12 months, you should invest in ultra short term debt funds (previously known liquid plus funds). Ultra short term debt funds give higher returns than liquid funds.

Investment Objective: Liquid funds are suitable for investors who have substantial amount of cash lying idle in their savings bank account.

Apart from these six categories of debt funds, there is another category known as Monthly Income Plan (MIP). Since MIPs are essentially hybrid investments, which invest about 75% in debt securities and 25% in equities, it is outside the scope of this discussion.

Debt Fund Taxation

If units of debt mutual funds are redeemed within 36 months of purchase, then short term capital gains is calculated by subtracting the purchase cost from sales consideration. Short term capital gains is added to the income of the investor and taxed as per the income tax rate of the investor. If the units are redeemed after 36 months from the date of purchase then long term capital gains apply. Long term capital gains for debt mutual funds are calculated by subtracting the indexed cost of purchase from the sales consideration. The indexed cost of purchase is calculated by multiplying the actual cost of purchase with the ratio of cost of inflation index in the year of redemption and the year of purchase. Cost of inflation index table is published by the Reserve Bank of India and is available in the public domain. Long term capital gains for debt mutual funds are taxed at 20.6% (including education cess) after indexation.

Conclusion

Debt funds can address a variety of investment objectives and have solutions in any interest rate scenario. In this article, we have discussed different type of debt funds and their risk return characteristics. Investors should consult with their financial advisors and discuss which debt funds will be suitable for their investment objectives.

Disclaimer:

Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content developed in this article has been provided by Advisorkhoj.com and is to be read from an investment awareness and education perspective only. SBI Mutual Fund’s participation in this article is as an advertiser only and the views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader

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Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development

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