How to invest in Debt Funds?

Most of our parents and grandparents have invested their hard-earned money into trusted FDs, and PPFs and relied on gold for wealth creation. That was a good option a long time ago, but today, that’s a way to lose wealth than make wealth.

A bank deposit earns 6% per annum. The interest earned on the principal is taxed according to the tax bracket. If the tax bracket of the individual is 20%, the net interest earned is 6%*(1-20%) = 4.8%.

The current inflation ranging from 4% to 6%, erodes the wealth that is created by the bank deposit. Hence, in the current economic scenario, these instruments are not sufficient for beating inflation and creating wealth with reasonable returns over the years.

Debt as an investment vehicle has always been trusted as there is a fixed promised return and a guaranteed principal payment, giving a sense of comfort to the investor.

The debt market is a platform that enables the purchase and sale of loans in exchange for a rate of interest and periodic payments of the coupon.

These markets are lesser risky than their equity counterparts, and hence also have lower returns when compared to equity instruments. In the following article, we explore various facets of this financial instrument. 

What is a Debt Mutual Fund?

A debt fund is a mutual fund that invests in fixed-income instruments such as treasury bills, commercial paper, government bonds, corporate bonds/debentures, money market instruments, etc.

All the instruments that the fund invests in have a maturity and a fixed coupon or interest rate payment that the buyer/investor can rely on – hence have the name – fixed-income instruments.

These funds are also known as bond funds or fixed-income funds. As the returns are pre-decided, they are not affected by market fluctuations when the instruments are held until maturity. Hence, these funds are low-risk options for an investor.

Every debt security is assigned a credit rating which indicates the risk/probability of default, based on which the fund managers take a decision to either include or exclude them in their portfolios.

If a paper or debt security has a high credit rating, it implies a low probability of default i.e., the borrower has a high propensity to pay back the principal and interest.

Fund managers sometimes also choose a lower-quality debt to earn higher returns by taking a calculated risk. A debt fund with a higher amount of high-quality debt is more stable and less prone to market fluctuations however, earns a lower return.

The fund manager also has the flexibility to choose long-term or short-term debt based on the existing yield curve or interest rate regime in the economy. 

Types of Debt Funds

Debt funds are classified based on the maturity period as follows –

Liquid Fund: This fund invests in money market instruments that have a maturity of fewer than 91 days (3 months). The returns earned by these funds are greater than the savings accounts.

These are considered one of the best alternatives for liquid and short-term investing.

Gilt Fund: These invest over 80% of the assets into Government securities over a range of maturities (10 years, 5 years, etc). These funds are credit risk-free (as one is lending to the Government of India, which cannot default on its payments), however, are highly vulnerable to interest rate risk.

Dynamic Bond Fund: These invest in debt securities with a range of maturities, adjusting for the interest rate regime or yield curve prevailing in the economy. These funds are ideal for investors seeking moderate risk with an investment horizon of 3-5 years.

Money Market Fund: The fund invests in debt securities with a maturity of less than 1 year. These are sought after by investors looking for short-term investment options in low-risk vehicles.

Corporate Bond Fund: This fund invests over 80% of the assets in corporate bonds with the highest credit rating (implying a low risk of default). These are suitable for investors seeking low risk and provide exposure to corporate bonds which provide higher returns than the G-secs.

Banking and PSU Fund: The fund invests over 80% of its assets in Banks and PSU bonds.

Credit Risk Fund: These funds are mandated to invest over 65% of their assets in bonds with a credit risk rating below AA+. They aim to generate a return higher than the funds invested in G-secs and other high credit-rating debt securities, by taking on more risk in their portfolios.

However, these funds only thrive in a credit conducive environment where the economy is booming. These funds are very volatile and are suitable for investors seeking moderate-high risk.

Floater Fund: These funds invest over 65% of their assets in bonds with a floating interest rate. One should consider investing in floater funds when there is a rise in interest rates in the economy to reap the maximum benefits.

Short-term floater funds typically invest in Government securities with a tenure of less than one year. Longer-term floater funds invest in corporate bonds, debentures, and government bonds. Flexibility in tenure makes it an attractive investment to all investors in the market.

Despite these funds providing higher returns (lower than equity funds), they are heavily reliant on market conditions, implying uncertainty in the prediction of returns that can be expected from these funds.

Investors looking to make gains from the interest rate fluctuations, dilute the interest rate risk factor in their portfolio, or have their wealth unaffected by the volatile market fluctuations prefer to invest in these funds.

Overnight Fund: These invest in securities with a maturity of 1 day. Due to the extremely small-time horizon, the interest rate and credit risk are almost negligible (SEBI also mandates these funds to invest in low-risk debt securities).

The returns earned from these funds are also lower ranging from 3-5%. These funds do not charge exit loads even when the units are redeemed in a day, which was the primary reason for their popularity among investors.

What is Macaulay’s duration?

This financial jargon indicates how many years it would effectively take for the bond to repay back to the investor with its periodic cash flows. It can also be considered as the time at which the investor’s investment reached a breakeven.

It is also used as an indicator for the interest rate sensitivity of the bond, the higher the duration, the higher the sensitivity. The following table indicates the type of bonds that the funds would invest in depending on their fund type.

FUND TYPE	Macaulay Duration
Ultra-Short Duration Funds	3-6 months
Low Duration Fund	6-12 months
Short Duration Fund	1-3 years
Medium Duration Fund	3-4 years
Medium – Long Duration Fund	4-7 years
Long Duration Fund	>7 years

What type of Investor should invest in Debt Funds?

Debt funds are considered ideal for risk-averse investors who aim to generate a regular income out of their investments. The funds diversify across various securities and ensure a stable return to their investors.

If an investor has been saving in bank deposits for their stability, then he/she could prefer debt mutual funds and earn similar or higher returns in a tax-efficient manner. The funds are available for short-term (3-12 months) and medium-term investors (3-5 years).

As an investor, if you are looking for a more liquid investment, you could prefer a short-term fund over a savings account and earn 7-9%.

Monthly Income Plans (MIPs) also provide an option for the investor to receive a monthly payout, similar to FDs.

Risks in debt funds

We are not suggesting that debt funds are risk-free. That tag only belongs to the Government of India (Sovereign Debt). The underlying risks that one must consider while investing in debt funds are as follows –

• Liquidity Risk: In an economic downturn, the fund house could receive an umpteen number of redemption requests from the pool of investors. There is a possibility that the fund may not have enough cash and cannot sell/reverse their positions due to the economic conditions to oblige to all the requests. This risk is known as liquidity risk.
• Interest Rate Risk: When the interest rates increase, the NAV of the fund falls. In case of the interest rate decline, the value of bonds in the portfolio increases, due to their higher pre-decided coupon rates. This also pushes the NAV of the debt funds in an upward direction. Hence, the NAV of the fund is prone to interest-rate fluctuations in the economy.
• Credit Risk: The probability of default, i.e., the event when the borrower does not pay the principal and interest. 

Expense Ratio: It is the fees paid to the fund house for managing your money. One should also consider this expense while investing in a debt fund. These funds earn lower returns than their equity counterparts. If the expense ratio is high, it could dent future returns/earnings.

Hence, it is always advisable to stay invested for a longer duration and to choose funds with a lower expense ratio.

Benefits of debt funds

• High Liquidity: Debt funds are typically considered alternatives to fixed deposits. Along with providing recurring returns, debt funds (especially liquid funds and overnight funds) have high liquidity where investors can redeem their investments in the shortest time frame.
• Investment Horizon: There are umpteen options available for any type of investment horizon that is preferred by the investor – a large number of options to choose from and hence make a portfolio customized for yourself.
• Higher Returns: The debt funds provide a higher return than the typical FDs, and savings accounts.
• Tax Efficiency: The interest rate earnings are taxed every year in the case of FDs. However, in the case of debt mutual funds, the investor reaps the benefits of indexation after a holding period of 3 years.
• Flexibility: The funds also provide an option to transfer the units to equity schemes if the investor is ready to take on additional risk for higher returns. Such options or alternatives are absent in the traditional route of FDs and bank deposits.