Debt mutual funds invest in a variety of fixed income securities like treasury bills, commercial papers, certificates of deposit, corporate bonds and government bonds, primarily with the objective of generating income for investors.
How are returns generated by debt funds?
Almost all fixed income securities have a specified maturity period. They pay periodic (e.g. quarterly, yearly etc.) interest and pay the principal amount upon maturity. Some short term debt securities (also known a zero coupon bonds) do not pay periodic interest; they are issued at discount (lower price) to face value (principal) and pay the principal on maturity.
After issuance, fixed income securities can be bought or sold in debt markets at market prices. Market price of these securities move up or down with interest rates. If interest rate goes down the price of fixed income securities go up and vice versa. So if you have invested in a bond and sell it after interest rate has fallen, in addition to the interest paid to you over your holding period, you will also make a profit from price appreciation because the bond price will be higher. In debt funds you can get both income (interest) and capital appreciation during the holding period.
Factors influencing debt funds
Like all market linked products debt funds are also subject to risks. There are two kinds of risk in debt funds:-
- Interest rate risk: Bond prices have an inverse relationship with interest rate changes. In the previous section, we stated that price of a bond will rise, if interest rate falls and you can make a profit. The flipside is that if interest rate rises, then bond price will fall and you can make a loss, if you are selling before maturity. This is interest rate risk. The sensitivity of a bond’s price to interest rate change depends on the maturity of the bond. Longer the maturity, more sensitive is the bond to interest rate changes. For example, if interest rates rise by 0.5% the price of 10 year bond will fall much more than a 2 year bond.
- Credit risk: Credit risk refers to the issuers’ failure of meeting their interest and / or principal payment obligations, exposing the investor to potential loss of income and / or capital. To explain this in simple terms if due to poor sales a company’s operating income is not sufficient to make interest payments to bond-holders then it will default i.e. not able to make the payment. If the company’s financial situation does not improve when the bond matures and it is not able secure funds from other sources, it will not be able to repay the principal as well causing a loss to investors. This is credit risk. Credit rating agencies assess the credit risk of different fixed income securities and assign credit ratings. Higher the credit rating of a bond, lower is the credit risk.
Interest rate risk and credit risk differs from fund to fund. You should factor these two risks when selecting debt funds for investments and make informed decisions based on your investment needs and risk appetites.
Why should investors look at debt funds?
- Debt funds offer a wide range of investment solutions for different investment needs and tenures. There are funds where you can park your money for just a few days and earn higher returns than savings bank interest, another set of funds where you can invest for a few months to a year. There are funds which are suitable for 2 – 3 year tenures and funds suitable for longer investment tenures.
- Debt funds offer a wide range of investment solutions for different risk appetites. Different types of debt funds have different interest rate risks. If you prefer low volatility, you can invest in a fund which has low interest rate risk. If you have longer investment tenures and have appetite for volatility, you can invest in other categories of funds, which can give you superior returns over sufficiently long investment tenures.
- Open ended debt funds are highly liquid investments. You can redeem units of your debt fund, partially or fully at any time. If you redeem your units after the exit load period, there are no charges. Many debt funds do not have any exit load – there are no charges for early withdrawals unlike several traditional fixed income investments. Read the scheme information document before investing. Several traditional fixed income investment options like Government Small Savings Schemes are not as liquid as open ended debt funds.
- Debt funds have the potential to give higher returns than traditional fixed income investment options like Bank Fixed Deposits and Government Small Savings Schemes. Top performing debt funds across several categories have outperformed traditional fixed income investment options over similar tenures over the last 3 years.
- Debt funds are much more tax efficient than bank FDs and several other traditional fixed income investment options over 3 years plus investment tenures. Capital gains in debt funds held for 3 years or longer are taxed at 20% after allowing for indexation benefits. For long term investors in higher tax brackets, debt funds certainly offer significant tax advantage compared to traditional fixed income investment options like bank FDs.
How debt funds help in portfolio allocation
Debt funds are generally much less volatile than equity funds. Your allocations to debt funds will provide stability to your portfolio when equity market is volatile. The chart below shows the annual returns of equity and debt asset classes over the last 10 years. We have used BSE 100 TRI as a proxy for equity and CRISIL Short Term Bond Fund Index as a proxy for debt.
Source: Advisorkhoj Research
Different types of debt funds
There are a large variety of debt fund products addressing a wide spectrum of investor needs. Let’s discuss 7 major and common debt fund categories.
- Overnight Funds: These debt funds invest in fixed income instruments which mature overnight. These instruments have virtually no interest rate risk. Also overnight instruments are backed by collateral which comprises of Government Securities. So, these funds also have no credit risk. Overnight funds are suitable for parking your funds for a few days.
- Liquid Funds: Liquid funds invest in debt and money market instruments like commercial papers, certificates of deposits (CDs), Treasury bill etc. which mature within 91 days. Due to the very short maturities of their underlying instruments, liquid funds have very low interest rate risk. However, liquid funds may have exposure to credit risk depending on the credit quality of the underlying instruments. High credit quality liquid funds have very low risk and offer higher returns than savings bank. According to SEBI directive, these funds charge graded exit loads for withdrawals within 7 days from the date of investment. Liquid funds are suitable for parking your funds for a few weeks or months.
- Short duration Funds: Short duration funds invest in debt and money market instruments such that the Macaulay Duration of the portfolio is between 1 – 3 years. In simplified terms, Macaulay Duration is the interest rate sensitivity of a fixed income instrument. Due to their relatively short duration profiles, short duration funds have limited interest rate risk. These funds aim to hold the instruments in their portfolio till maturity and earn interest paid by them. These funds may also have exposure to credit risk depending on the credit quality profile of their underlying instrument. Short duration funds are suitable for 2 – 3 year investment tenures. Investors can avail of long term capital gains tax benefits for 3 years + investment tenures.
- Corporate Bond Funds: Corporate bond funds are debt mutual fund schemes which invest at least 80% of their assets in highest rate corporate bonds. Since corporate bonds are subject to credit risk, their yields are higher than those of Government bonds. The returns of corporate bond funds are therefore, usually higher than debt mutual funds of similar duration profiles which invest primarily in Government bonds. These funds are suitable for 3 year investment tenures.
- Dynamic Bond Funds: Dynamic bond funds have the flexibility to invest across durations depending on their interest rate outlook. Dynamic funds by nature can manage duration actively by taking tactical calls and thereby optimises duration risk. Investors should have appetite for short term volatility and a sufficiently long investment horizon. Investors should have at least 3 years or longer investment horizon for these funds.
- Long duration Funds: Long duration funds invest in debt and money market instruments such that the Macaulay Duration of the portfolio is more than 7 years. Due to their relatively long duration profiles, these funds have high interest rate risk but they can give superior returns in favourable interest rate scenarios over long investment tenures. Investors should have at least 3 years or longer investment horizon for these funds.
- Gilt Funds: These funds invest at least 80% of their assets under management (AUM) in Government Securities. Hence these funds have very low credit risk. However, these funds have high sensitivity to interest rate changes. They can give very high returns when yields are falling but can be quite volatile in the short term if yields spike due to any reason. Investors should have high appetite for volatility and at least 3 years or longer investment tenures for their Gilt fund investments.
Bank FD interest rates have been falling over the last few years now. With RBI’s interest rate cut in May 2020, banks have reduced FD interest rates to historic low levels. Naturally many investors who relied on bank FDs as traditional investment choices are concerned. Debt funds are good alternative to fixed income investment options for investor due to the reasons discussed above. Unlike bank FDs, debt funds are not risk-free investments. Fortunately, debt funds offer a range of products across different risk profiles.
As an investor, you should always understand the risk of a product in order to make informed investment choices. Hopefully, through this article we have increased your knowledge about debt funds. Please consult with your financial advisor before taking any investment decision.
Additional reading – infographic on debt funds
Issued as an investor education initiative
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.