Investing in Debt Funds

Depend on debt funds to enhance the overall value of your portfolio.

When it comes to investing in mutual funds in India, retail investors typically tend to think of equity mutual funds. Little do they know that debt funds too offer several advantages and can help augment one's portfolio. Here is all you need to know about debt funds and investing in them.

What are Debt Funds?

Debt mutual funds are funds that invest in instruments such as government securities, corporate bonds, commercial paper (CP), certificate of deposits (CD), T-bills and other such debt and money market instruments. They are called "debt" because the issuers of such instruments borrow money from lenders against these instruments. These instruments come with different maturities and can generate income periodically or at maturity.

Since most debt instruments are not available for direct purchase by retail investors (because the minimum amount required to invest is pretty high), debt mutual funds are the ideal way to invest in them. Debt funds usually provide the benefit of capital appreciation when interest rates fall. There are various kinds of debt funds that can feature in an investor's portfolio depending upon his/her investment goals and risk appetite. Here are the generic categories.

Types of debt funds

1. Liquid funds: Liquid funds predominantly invest in liquid instruments and debt securities with maturity periods not exceeding 91 days, thereby providing high liquidity. Such instruments typically include treasury bills, commercial papers, certificates of deposits, and collateralized lending and borrowing obligations. These funds may be an attractive alternative to corporate and individual customers as a means to deploy their idle funds for short periods, which could be as low as one day. 
2. Ultra-short-term funds: Ultra-short-term funds are funds that are of a short duration and generally invest in debt securities with short-term maturities such that the Macaulay Duration of the portfolio is between 3 months - 6 months. They invest in a range of money market and debt instruments. These funds are ideal for individual and corporate customers looking to invest their idle funds. These funds are optimal for customers looking for cash management or where the investment horizon is short-term. 
3. Low Duration Funds: Low duration funds invest in debt and money market instruments such that the Macaulay Duration of the portfolio is between 6 to 12 months.
4. Money Market Funds: Money market funds are funds that invest into Money Market instruments with maturity up to 1 year.
5. Short duration funds: Short term funds invest in corporate and government bonds with  duration ranging between 1 and 3 years. These funds cater to customers that prefer low to medium duration risk.  
6. Medium duration funds: Medium duration funds invest in medium term corporate bonds and government securities with a maturity mix that is aligned to the interest rate outlook. The duration of the portfolio is between 3 years and 4 years. Portfolio duration under anticipated adverse situation can be 1 year to 4 years. These funds are suitable for customers that are looking to benefit from falling interest rates or higher yield. 
7. Corporate Bond Funds: These funds predominantly invest in corporate bonds with a credit rating of AA+ and above. There shall be a minimum exposure of 80% in such corporate bonds.
8. Credit Risk Funds: These funds invest in corporate bonds that are rated AA and below with a minimum exposure of 65% in such securities.
9. Banking and PSU Fund: These funds predominantly invest in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds. The minimum investment in such instruments should be 80 percent of total assets.
10. GILT funds: The primary objective of GILT funds is to generate credit risk-free returns through investments in sovereign securities issued by the GoI or state governments. Minimum investment in Gsecs- 80% of total assets (across maturity)
11. Floating Rate Funds: Variants of income funds that minimize the volatility risk by predominantly investing floating rate debt securities. Minimum investment in floating rate instruments- 65% of total assets
12. Fixed-maturity plans: Fixed-maturity plans are closed-ended debt funds that generate income through investment in debt and money market instruments as well as government securities maturing on or before the maturity date of the plan. These are best suited for customers seeking accrual of income with minimal duration risks. 

There are other lesser known categories of debt funds that can meet specific goals of investors. These are:

• Monthly Income Plans (MIPs)- Debt oriented hybrid funds that invest a part of the corpus of such funds in equities with the objective of generating regular income and long-term capital appreciation.
• Capital Protection Funds (CPFs)- Close-ended funds where allocation of funds is done in such a way as to keep the value of the investment equal to the original investment amount, thereby protecting the capital of the investor. A portion of the corpus of such funds is also invested in equities to enhance the returns of these funds after maturity.

Benefits of investing in debt funds

• Diversification - Investing a certain portion of your assets in debt funds shields your portfolio from the volatility of equity investments.
• Managing risks - Investing in debt funds reduces the risk of losses as these funds are less volatile as compared to equities.
• Opportunity to invest in debt instruments - Debt mutual funds provide retail investors the opportunity to invest in various debt instruments such as Government securities, bonds, Non Convertible Debentures (NCDs), etc. that retail investors otherwise cannot participate in because of higher investment limits.
• Regular income - Debt mutual funds help in generating regular income by way of dividend distribution. Depending upon the type of debt fund, these dividends can be daily, weekly, fortnightly, monthly, semi-annually or annually.
• Advantage of interest rates - If an investor selects the right type of fund matching his risk appetite and investment time horizon, he may be able to generate income in line with the prevailing rates of interest.
• Opportunity to park short-term surplus - Unlike equity mutual funds that prove to be very volatile in the short-term, some debt funds provide the opportunity to retail investors to park their surplus for a short while and earn decent returns on it.

How to evaluate debt funds

Debt funds can provide benefits for investors if they fit in with their overall investment objectives. To assess whether these funds fit into your investment objectives you need to evaluate them properly. You can evaluate debt funds on the basis of the following parameters:

• Portfolio - These give the list of instruments that the fund has invested in, thus giving an insight into its investment strategy.

• Maturity profile - Can be used to understand the composition of the portfolio.

• Yield to maturity - This is a measure of interest income that can be earned from the portfolio. This should be compared to the current returns of your other safer instruments.

• Credit rating - The quality of credit can be seen to understand how vulnerable the fund can be to credit risk. The lower the rating, the more the risk of a default.

• Average portfolio maturity - Gives the indication of the length of time in which the principal amount of the bond will be repaid.

• Duration of portfolio - Can be examined to see the price sensitivity of the portfolio in a changing interest rate scenario. This can give an indication of how volatile the fund can be to interest rate risk.

• Average maturity and duration - A portfolio of bonds consists of a number of instruments with different maturities. Average maturity is the weighted average of the time left up to maturity. A fund that has a higher maturity and duration can be expected to perform well in a scenario where interest rates are falling and vice versa. Bond prices and interest rates are inversely related; the longer the tenure of the bond the more sensitive it is to changes in interest rates.

Things to keep in mind when investing in debt funds 

Now that you know how to evaluate debt funds, you must know how to choose debt funds that are right for you. Here are the factors that you should keep in mind:

• Your current asset allocation and risk tolerance

Firstly, you must carefully consider your overall asset allocation in the context of your investment objectives. Depending upon your investment horizon and the risk appetite, arrive at the ratio of debt and equity. Ideally, by maintaining a good balance between debt and equity you can achieve long-term growth and reap the benefits of reasonable returns.

• The market environment

The predominant factor that influences the performance of debt funds is the interest rate. Keeping an eye on interest rate movements and trying to comprehend their implications will give you a good idea of how your debt funds will perform.

• Expense ratio and exit loads

As returns are comparatively low on debt funds the expense ratio becomes a critical consideration for debt funds. Further, most debt funds are subject to exit loads to dissuade investors from exiting prematurely and taking a short-term view on interest rates. This should also be taken into consideration before taking a call on making an investment in debt funds.

 

Conclusion

When equity markets are on a high, debt funds are usually the last thing on the mind of investors. What investors are usually unaware of is that debt funds are the best way to counter the equity market volatility. If a careful choice is made across debt fund categories keeping in mind one's overall investment objectives, debt funds can offer the benefits of capital appreciation and yield reasonable returns over a period of time.

 

 

The information contained in this document is for general purposes only and not an investment advice. Readers should seek professional advice before taking any investment related decisions.

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