Green Tree Distribution recommends investments after discussions with a mutual fund distributor or a Certified Investment advisor
Debt mutual funds are subject to market risks. Please read offer documents before investing.
What are Debt Mutual Funds :
A debt fund is a Mutual Fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also referred to as Fixed Income Funds or Bond Funds.
A few major advantages of investing in debt funds are low cost structure, relatively stable returns, relatively high liquidity and reasonable safety and significant tax advantage due to indexation benefits in the long term capital gains tax calculation after 3 years .
Debt funds are ideal for investors who aim for regular income, but are risk-averse. Debt funds are less volatile and, hence, are less risky than equity funds. If you have been saving in traditional fixed income products like Bank Deposits, and looking for steady returns with low volatility, debt Mutual Funds could be a better option, as they help you achieve your financial goals in a more tax efficient manner and therefore earn better returns.
In terms of operation, debt funds are not entirely different from other Mutual Fund schemes. However, in terms of safety of capital, they score higher than equity Mutual Funds.
Is there a risk in Debt Mutual Funds?
There is a lot of misunderstanding among the investors regarding the safety of debt instruments as an investment opportunity and many consider it as safe as fixed deposits if not more unaware about the risks in debt mutual funds.
Many intermediaries in the market promote debt funds in a similar way to investors. But the degree of risk is lower as compared to Equity as an asset class.
The answer to this is plain and simple – Even debt is risky and can give negative return hence there are risks in debt bonds and mutual funds
Lets understand the risks involved in the debt mutual funds and the various debt mutual funds instruments available and also understand the risk-reward ratio of these funds.
A debt mutual fund is a collection of various debt bonds and debt securities that are aligned with the objective of the fund.
Debt mutual funds have below mentioned risks –
1. Liquidity risk
The bonds/securities in the mutual funds should be liquid in nature so that when an investor is willing to sell his units the bonds can be sold and the money is paid back.
There are some debt mutual funds which are not that liquid in the secondary market hence getting the money back at the time of need can be very challenging.
2. Reinvestment Risk
Let us understand this with an example – During 2008 the interest rates on fixed deposits were higher (10.5% for 1000 days deposits and 9.25% for 8 to 10 years deposits).
If there was an investor who didn’t needed the money for 10 years and has done the fixed deposit for a tenure of 10 year he would have got that yield even in 2021 when the interest rates have come down to a paltry 5%.
But as an investor, we have a tendency to do these deposits for 1 year on an auto-renewal mode, and also due to lack of understanding or lack of right guidance we don’t have a viewpoint on an interest rate movement.
So the fixed deposit which has recently matured (since it matures every year) is now facing a risk to be re invested at a lesser prevailing interest rate – this risk is technically called reinvestment risk.
In the economy where the interest rate is declining the fund manager is facing the risk of reinvesting the maturity amount at a lower current prevalent rate.
3. Credit risk
The bonds which are constituents of debt mutual funds are rated for their quality as per SEBI guidelines by various rating agencies like CRISL, ICRA, CARE etc and depending upon the ratings are the safety of the bonds as well as yield.
For example, an AAA+ (highest rated) bond is the safest bond with lesser chances of a default hence the lesser interest rate on offer whereas a BB- has a higher chance of default hence it offers a higher yield (premium for its lower credit quality).
The kind of risk associated with the credit quality of a bond is not only associated with the default of the bond rather there is also a possibility of a downgrade or upgrade of the bond rating.
A fund manager buys a low rated bond with the possibility of the bond being upgraded and hence providing an upside to the investor whereas in case the bond is downgraded the investor faces the risk of credit default.
4. Interest rate risk
This is the most important type of risk.
Interest rate risk measures the price movement of bonds with respect to change in interest rates. The price of the bond is inversely related to the change in interest rate.
How do Debt Funds work
Debt funds invest in a variety of securities, based on their credit ratings. A security’s credit rating signifies the risk of default in disbursing the returns that the debt instrument issuer promised. The fund manager of a debt fund ensures that he invests in high rated credit instruments. A higher credit rating means that the entity is more likely to pay interest on the debt security regularly as well as pay back the principal upon maturity.
Debt funds which invest in higher-rated securities are less volatile when compared to low-rated securities. Additionally, maturity also depends on the investment strategy of the fund manager and the overall interest rate regime in the economy. A falling interest rate regime encourages the fund manager to invest in long-term securities. Conversely, a rising interest rate regime encourages him to invest in short-term securities.
Who should invest in Debt Funds :
Debt funds try to optimize returns by investing across all classes of securities. This allows debt funds to earn decent returns. However, the returns are not guaranteed. Debt fund returns often fall in a predictable range. This makes them safer avenues for conservative investors. They are also suitable for people with both short-term and medium-term investment horizons. Short-term ranges from three months to one year, while medium-term ranges from three years to five years.
Types of Debt Funds :
Overnight Fund :
Investment in overnight securities having maturity of 1 day An open ended debt scheme investing in overnight securities
Liquid Fund :
Investment in Debt and money market securities with maturity of upto 91 days only An open ended liquid scheme
Ultra Short Duration Fund :
Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 months - 6 months An open ended ultra-short term debt scheme investing in instruments with Macaulay duration between 3 months and 6 months
Low Duration Fund :
Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 6 months- 12 months An open ended low duration debt scheme investing in instruments with Macaulay duration between 6 months and 12 months
Money Market Fund :
Investment in Money Market instruments having maturity upto 1 year An open ended debt scheme investing in money market instruments
Short Duration Fund :
Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 1 year – 3 years An open ended short term debt scheme investing in instruments with Macaulay duration between 1 year and 3 years
Medium Duration Fund :
Investment in Debt & Money Market instruments such that the Macaulay An open ended medium term debt scheme investing in instruments with Macaulay duration between 3 years and 4 years
Medium to Long Duration Fund :
Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 4 – 7 years An open ended medium term debt scheme investing in instruments with Macaulay duration between 4 years and 7 years.
Long Duration Fund :
Investment in Debt & Money Market Instruments such that the Macaulay duration of the portfolio is greater than 7 years An open ended debt scheme investing in instruments with Macaulay duration greater than 7 years
Dynamic Bond :
Investment across duration An open ended dynamic debt scheme investing across duration .
Corporate Bond Fund :
Minimum investment in corporate bonds- 80% of total assets (only in highest rated instruments) An open ended debt scheme predominantly investing in highest rated corporate bonds
Credit Risk Fund :
Minimum investment in corporate bonds- 65% of total assets (investment in below highest rated instruments) An open ended debt scheme investing in below highest rated corporate bonds.
Banking and PSU Fund :
Minimum investment in Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions- 80% of total assets An open ended debt scheme predominantly investing in Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions.
Gilt Fund :
Minimum investment in Gsecs- 80% of total assets (across maturity) An open ended debt scheme investing in government securities across maturity
Gilt Fund with 10 year constant duration :
Minimum investment in Gsecs- 80% of total assets such that the Macaulay duration of the portfolio is equal to 10 years An open ended debt scheme investing in government securities having a constant maturity of 10 years
Floater Fund :
Minimum investment in floating rate instruments- 65% of total assets An open ended debt scheme predominantly investing in floating rate instruments
Fixed Maturity Plans :
Fixed maturity plans (FMP) are closed-ended debt funds. These funds also invest in fixed income securities such as corporate bonds and government securities. All FMPs have a fixed horizon for which your money will be locked-in. This horizon can be in months or years. However, you can invest only during the initial offer period. It is like a fixed deposit that can deliver superior, tax-efficient returns but does not guarantee high returns.
Things to consider as an investor
Risk :
Debt funds suffer from credit risk and interest rate risk, which makes them riskier than bank FDs. In credit risk, the fund manager may invest in low-credit rated securities which have a higher probability of default.
In interest rate risk, the bond prices may fall due to an increase in the interest rates.
Return :
Even though debt funds are fixed-income havens, they don’t offer guaranteed returns. Though returns are not constant they will out perform Fixed Deposits both in yield and tax benefits.
Cost :
Debt fund managers charge a fee to manage your money called an expense ratio. Considering the lower returns generated by debt funds as compared to equity funds the charges on debt funds are far lower than equity mutual funds.
Investment Horizon :
If you have a short-term investment horizon of zero to three months, then you may go for liquid funds. In Debt funds your investment horizon plays a key role in fund selection and various debt funds are available for different investment horizons.
Financial Goals :
You can use debt funds as an alternative source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for balancing risk in their portfolio . Retirees may invest the bulk of retirement benefits in a debt fund to give stability to their portfolio.
Taxation :
Capital gains from debt funds are taxable. The rate of taxation is based on the holding period, i.e., how long you stay invested in a debt fund. A capital gain made during a period of lesser than three years is known as a Short-Term Capital Gain (STCG). A capital gain made over three years or more is known as Long-Term Capital Gains (LTCG). The Capital gains Tax on the Debt Mutual fund for an investment period over 3 years is the LTCG tax rate which is 20% of the gains based on Indexed cost .This is significantly lower compared with the tax rate on gains in other fixed income products in the market. (Company deposits , Fixed deposits with banks etc)