ABCD of Debt Mutual Funds

Debt mutual fund is most neglected type of mutual fund when it comes to awareness in general public. That;s why, during my discussion with my clients on their portfolio and asset allocation, this was most difficult type for them to understand. General investors thinks mutual fund means only stock market. In reality however , debt funds have a large share in overall mutual fund assets. Corporate investors use it effectively for their investments but lack of awareness in retail investors keep them away from this category. In this article, I will try to explain basics of debt funds and see and hope it will help few in investing in them. Let’s start.

A for asset. Where does Debt fund invest money?

Let’s start with first thing which is trying to understand where does money go that we invest.
Debt mutual funds invest in fixed income securities and not in stock market. So stock market do not impact them directly. In simple term say central and state governments, companies and even banks need money from time to time. Sometimes just for a day, sometimes for weeks or months or in some cases for years. They all borrow money by issuing various products like bonds, treasure bills, certificate of deposits, debentures, corporate fix deposits etc. Don’t worry if you don’t understand what are these. Basically these are loans taken for some work. Borrower would later repay loan and interest as agreed in product.

If interest rate is higher than say bank fixed deposit, we would be interested. Right? But for you and me, it may not be easy, convenient or even feasible in some cases to directly participate in these products. Here debt funds offer us a easy solution. Money invested by us in debt funds would in turn get invested in these fixed income securities and based on interest received, even our investment would grow. So there is no relation to shares here. That is reason they are relatively less volatile and safer compared to equity fund. As risk is less compared to stock market, even their returns are generally lower compared to equity funds.

B for Balancing Act

Though return are less in debt funds compared to equity, they have very critical role to play in your portfolio. They are provide required cushioning effect to reduce volatility of equity in your portfolio with steady returns. They are good alternatives to money in savings account, fixed deposits, debentures and similar investments as they offer good diversification in very small amount. All types of investors, be it conservative , balanced or aggressive should have debt funds in their portfolio in different proportions.

1) Conservative investors – Debt investments are less volatile and less risky compared to say equity instruments. If you are person with low risk appetite and looking for alternatives to say bank fixed deposit for better returns, this could be for you. You may not be ready to take risk of equity. Debt funds can form large part of your portfolio.

2) Balanced investor – If you are investor with balanced risk profile then you need some portion of your portfolio in debt funds. This will prevent major down slide in value of your portfolio if stock market crashes. Debt funds will protect your portfolio from going down steeply and overall impact on your portfolio would be lesser.

3) Aggressive investor – Even if you are aggressive investor, you need diversification across assets. Debt funds can be used for same but proportion of them in overall portfolio could be small.

Also irrespective of risk profile, equity is not suitable for short term goals like investing money for say buying car in year or two, or contingency fund which may be needed at any time etc. Debt funds are good option to consider in such cases.

Also since volatility in debt funds is very less, you need not go SIP (Systematic Investment Plan) route for debt funds. If you have lump sum money available, you can invest it in one go. Of course, if you are a salaried person and as part of some short term goal, want to invest every month, that is also fine.

C for categories – What are different types of debt mutual funds?

Based on tenure of underlying debt instrument (or in simple term loan) and type of debt instruments, there are different categories of debt funds. Generally it is good idea to align timeline of your goal and mutual fund average tenure while investing. Few important categories useful for users like us are as under. These categories are simple to understand based on characteristics and description but if you have any queries, do post in comments.

1Liquid FundInvestment in Debt and money market securities with maturity of upto 91 days onlyAlternative to saving account or emergency funds
2Ultra Short Duration FundInvestment in Debt & Money Market instruments such that the weighted average maturity duration of the portfolio is between 3 months – 6 monthsSay you have money to give down payment for a house in next 3-6 months.
3Low Duration FundInvestment in Debt & Money Market instruments such that the weighted average maturity duration of the portfolio is between 6 months- 12 monthsSimilar to above but when your requirement is between 6 to 12 months
4Money Market FundInvestment in Money Market instruments having maturity upto 1 yearSimilar to above
5Short Duration Fund Investment in Debt & Money Market instruments such that the weighted average maturity duration of the portfolio is between 1 year – 3 years Say your daughter is in 10th and you need to invest money for her admission in medical field in 2 years
6Medium Duration FundInvestment in Debt & Money Market instruments such that the weighted average maturity duration of the portfolio is between 3 years – 4 yearWhen goal is around three years away.
7Medium to Long Duration Fund Investment in Debt & Money Market instruments such that the weighted maturity duration of the portfolio is between 4 – 7 yearsOverall long term investment
8Long Duration Fund Investment in Debt & Money Market Instruments such that the weighted maturity duration of the portfolio is greater than 7 yearsOverall long term investment
9Dynamic BondInvestment across durationWhen you want fund manager to take best decision as to invest in which duration.
10Corporate Bond Fund Minimum investment in corporate bonds- 80% of total assets (only in highest rated instrumentsAlternative to people investing in corporate FDs
11Credit Risk FundMinimum investment in corporate bonds- 65% of total assets (investment in below highest rated instruments) If you are ready to take some risk and want better returns.
12Banking and PSU FundMinimum investment in Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions- 80% of total asset
13Gilt FundMinimum investment in Gsecs- 80% of total assets (across maturityUnderlying assets are from Government so no risk of default.
14Gilt Fund with 10 year constant durationMinimum investment in Gsecs- 80% of total assets such that the weighted maturity duration of the portfolio is equal to 10 year
15Floater FundMinimum investment in floating rate instruments- 65% of total assetsInvestments will be of floating rate type and we can expect market interest rate as it changes.

Before investing in any debt fund, do refer above characteristics and check that it is in line with your objectives of investments. For example, when goal is say 2 years away, investing in liquid fund and getting lesser return is not a wise step. So chose category appropriately. Then selecting fund within that category will be less complex task as you will have few funds to consider.

D for Danger – So are debt funds risk free?

No. None of the mutual funds are risk free but they are comparatively safer compared to equity funds. Let’s look at risks to your money and what can be done to minimize it.

1) Credit risk – Since this is a loan like investment, if borrower defaults in repaying, it will impact the fund. How you can minimize this risk. Just check the portfolio of fund and make sure fund has distributed money across large number of instruments so default of one or two borrowers wont significantly ruin your money. Next check the ratings given to assets by rating agencies like CRISIL, ICRA or CARE. If ratings are good, then chances of defaulting is low.

2) Interest risk Decrease in interest rates increases bond prices and in turn your returns get additional boost. Vice versa is also true. So simply have some awareness about expected interest rates and if you feel interest rates are going to remain stable or decreases, you should be safe from this risk. Also note increase in interest rate is not really wipe out your money. Its just that your expected returns can be little lesser than what you anticipated.

3) Tenure Impact of interest rate is directly proportional to bond’s tenure. So if your fund invests mainly in long term loan instruments then appreciation or depreciation of your fund will be more if interest rate goes down or up respectively. So asking your advisor on average maturity period of loans (debt) in your fund is good thing to know. If your fund has assets with low average maturity (say 1 -2 years) then your are relatively less impacted by interest rate changes compared to fund with 4-5 years average maturity. If you are aggressive investor willing to take risk and feel interest rates are going to go down, you may chose fund with long tenure instruments and there by gain more of dip in interest rates.

E for Earning – How do we earn or get returns from Debt funds?

In simple term, you can think something like debt funds giving loan to government or banks or corporate and earn interest in return. This interest is main source of returns that you will get from a debt fund.
In addition to this, even interest rate changes impact value of these funds. If interest rate go down, value of assets invested by them goes up and if interest rate goes up, value goes down. However this change is not drastic like stock price change.

F for Finding or selecting right debt funds

  1. Chose the right category of debt fund in line with your goal and tenure
  2. Check portfolio of fund and ratings of investments done by them
  3. Look at consistency in performance compared to other funds in category
  4. Look at low expense ratio
  5. If you want to do proper research, use high alpha, low standard deviation values

T for Tax – How are debt funds taxed?

You need to pay tax for debt fund returns.

  1. Short Term Capital Gain(STCG) – If you sell debt funds in less than 3 years, you need to pay tax as per your income tax slab
  2. Long Term Capital Gain(LTCG) – If you hold it for more than 3 years then you have to pay LTCG at 20% with indexation benefit

    Although they are not as attractive as Equity Mutual Funds, they are still tax wise much better than normal bank or corporate fix deposits if held for more than 3 years.

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