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All you wanted to know about Passive Debt Investing

Aug 25, 2022 / Dwaipayan Bose | 15 Downloaded | 1128 Viewed | |
All you wanted to know about Passive Debt Investing
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Passive investing is becoming popular in India in recent years. As per AMFI July data, net Assets under Management (AUM) in passive funds multiplied by 3.5 times in the last years (source: AMFI, as on 31st July 2022). Exchange Traded Funds (ETFs), a type of passive fund, is now the largest mutual fund category in terms of AUM (source: AMFI, as on 31st July 2022)

What are passive funds?

Passive mutual funds invest in a basket of securities that track a market index. Unlike actively managed mutual funds, a passive fund does not aim to beat the market benchmark. In order to beat the benchmark, the fund manager of an active fund will have to construct the fund‘s portfolio differently from benchmark index. This will result in additional risk, over and above market risk. Passive funds are only subject to market risks; there is no additional risk. The other advantage of passive funds is cost. The cost of passive funds is much lower than actively managed mutual fund schemes. Exchange Traded Funds (ETFs), Index Funds, Passive Fund of Funds, etc are examples of passive funds.

What are passive debt funds?

Most retail investors usually associate passive funds with equity investments. However, in more recent times, passive debt funds have also been gaining in popularity. Passive debt funds are fixed income mutual fund schemes which track debt or money market instruments. These funds invest in debt or money market instruments like Government Securities (Gilts / G-Secs), State Development Loans (SDL), PSU bonds, and Tri Party Repos (TPTs) etc.

What are different types of passive debt funds in India?

There are mainly three kinds of passive debt funds in India viz. passive liquid funds, passive Gilt funds and target maturity funds. Passive liquid funds invest primarily in overnight instruments, while passive Gilt funds invest in Government Securities.

The vast majority of passive debt funds are target maturity funds. Target maturity funds are passive debt mutual fund schemes, which track an underlying bond index and have defined maturity dates. On maturity, you will get the maturity proceeds which will include the face value of the bonds in the fund portfolio and accrued interest.

How do target maturity funds work?

  • Target maturity funds invest in Gilts, SDLs and PSU bonds that mirror an underlying bond index. As such, the credit risk in target maturity funds is quite low.

  • Since target maturity funds hold bonds till maturity, you can lock in current yields by matching your investment tenure with the maturity of the fund.

  • Interest rate sensitivity of a bond is linked with bond maturity or duration. Longer the duration higher the interest rate risks. If you hold a bond till maturity, the interest rate risk will reduce over the tenure of your investment. Suppose, you invested in a 5 year bond and want to hold till maturity. After 1 year, the residual maturity of the bond will be 4 years, so the interest risk will be lower. After 2 years, the residual maturity of the bond will be 3 years, so the interest risk will be further lower.

Should you invest in target maturity funds or fixed maturity plan (FMP)?

Target maturity funds and fixed maturity plans (FMPs) are similar in the respect that both have fixed maturity dates. However, the major difference between target maturity funds and FMPs is liquidity. FMPs are close ended funds, which means that you cannot redeem the units of your FMP before maturity.

Target maturity funds are highly liquid. Target maturity ETFs trade on stock exchanges; you can sell units of your target maturity ETFs anytime on stock exchanges. Target maturity index funds or Fund of Fund (FOF) are open ended schemes. You can redeem units of the target maturity index funds or FOFs with the Asset Management Company.

Why invest in target maturity funds?

  • You can get predictable returns by matching your investment tenure with target maturity date of the fund. Since yields have risen sharply over the past 12 months or so, you can lock in the yields over a fixed investment tenure by investing in target maturity funds.

  • Target maturity funds are currently mandated only to invest in G-Secs, SDLs and PSU bonds. So credit risk is low.

  • There is no effect of interest rate changes on your returns, if your investment tenure matches with target maturity date of the fund.

  • For investment tenures of 3 years or longer, you can enjoy long term capital gains taxation benefits by investing in target maturity funds. Long term capital gains in debt funds are taxed at 20% after allowing for indexation benefits as opposed to traditional fixed income investment options e.g. bank FDs, which are taxed as per the income tax rate of the investor.

Conclusion

There is relatively less awareness about passive debt funds among retail investors in India. The objective of this blog post is to increase your awareness about these funds. These funds can serve a variety of investment needs. If you have Demat accounts then you can invest in debt exchange traded funds (ETFs). However, if you do not have Demat account you can invest passive debt Fund of Funds which in turn, invest in debt ETFs; many debt ETFs have corresponding FOFs.

You should consult with you mutual fund distributor to know more about passive debt funds and if they are suitable for your investment needs.

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