Debt Funds – With you through Storm and Calm
In every walk of our lives, we need someone to share things with – good or bad. Be it family, friends, spouse or relatives, one looks to share every joy and sorrow with the near and dear ones. The ones you can confide in during such times are the ones you expect to stick with you, through thick and thin. Good investments, like good relationships, stand by you even in bad times and stay with you when you need them the most. They give you strength and stability even in adverse times. Debt mutual funds are one such example of good investments which give you the potential to grow even in adverse times.
Debt Mutual Funds primarily invest in fixed income securities. Fixed income securities include government bonds, certificate of deposit, commercial papers, treasury bills, corporate bonds and such other instruments. But how do these funds provide stability and growth? Debt mutual funds invest in fixed income instruments which generate returns either through coupon receipts or capital appreciation (when the interest rates decline) or both. When interest rates are on the decline, debt mutual funds appreciate in value as these funds endeavour to benefit from the inverse relationship between prices of debt instruments and interest rates. Duration, interest rate movements & spreads between G-Sec and Corporate Bonds help these debt mutual funds to generate returns even when other investments do not go through the best of the times. Hence debt mutual funds can be viewed as ‘All Season Mutual Funds’.
Types of Debt Mutual Funds
Ultra Short Term & Liquid Funds:
Ultra short-term debt funds & Liquid funds invest in money market instruments such as certificate of deposits, commercial paper and treasury bills, of a duration usually lesser than 3 months (for liquid funds) and lesser than 1 year (for ultra-short term funds). These funds have no entry and exit loads in most cases. These funds offer highest degree of liquidity thus acting as an excellent avenue to park one’s surplus cash for short periods of time.
Such funds invest largely in short-term fixed income securities and maturity of papers is usually in the range of 1 to 3 years.
Medium Term Funds:
Medium Term Funds usually invest in a range of fixed income instruments having tenure of 3 years to 7 years. These funds generate returns from capital appreciation as well as from accrual or coupon income. A separate category of fund called Dynamic Bond Fund lies between Short Term and Long Term Funds. These funds can dynamically change their average maturities as per the view of the fund manager.
Income/ Long Term Fund:
Income schemes generally invest in fixed income securities of longer maturity. These funds are ideally suitable for investors who want to invest for long term and as part of their strategic allocation to debt funds. Managing interest rate risk gains utmost importance in this category of funds.
These are specialised funds which invest in only government securities with varying maturities. Since the investment universe of these funds are less risky government securities, these funds do not carry credit risks like other debt funds do.
There are other types of funds like Credit Opportunities Funds
which invest in instruments which might not necessarily be of the highest investible grade. These funds aims to benefit from a possible rating upgrade of such instruments. Other category called Monthly Income Plans are hybrid funds which invest predominantly in fixed income but also invest a smaller portion in equities. Like any other fund, the returns are market-driven, but their very name usually means that they declare monthly income. Though many such funds strive to declare a monthly dividend, they have no such obligation.
Advantages of Debt Mutual Funds:
They are less volatile than equity markets. Debt mutual funds invest in debt securities, where interest income is regular and prices are relatively stable
More liquidity & flexibility:
They are more liquid as compared to other available traditional savings options as investors can invest and withdrawal, fully or partially, at any time. However, some of them could have an exit load just like fixed deposits. An Investor can choose to change to other schemes, like from a debt fund to an equity fund, in same fund house
Potential for better post tax returns*:
Debt funds generate returns from coupon inflows and capital appreciation due to price movements. When interest rates are falling, deposits and traditional saving avenues start offering lower returns, but debt mutual fund are compensated as their value appreciates. The opposite happens when interest rates rise. Even if we assume that both these avenues generate similar returns, debt fund gains being subject to capital gains tax offer potential for better post-tax returns. This is because long term capital gains are taxed at 20% (plus surcharge and cess) with the added benefit of claiming indexation (adjusting the cost higher, to compensate for inflation).
* Subject to current Tax laws. For personal tax implication investors are requested to consult their tax advisors before investing.
How to select which Debt Fund to invest in?
One should always consider the overall asset allocation and assess the ratio of equities and debt investments in the portfolio of an individual. Over the long run, there should be a good balance between investments in equities and in debt. Once the right amount is decided, for investing in debt funds, one should evaluate maturity profile of the fund, credit risk (which can be seen by previous credit rating allocation of the fund) and other quantitative data like average maturity, exit load, YTM of the fund etc. Based on the investment horizon and the individual appetite to take risk one can match the investment need with the appropriate debt fund and invest. It is always advisable to consult an advisor or financial expert who can guide with regard to the best-fit as per the investor’s profile.