A Practical Guide on Investing in Debt Funds

The emergence of the pandemic in 2020 proved to be extremely dramatic, if not chaotic, for the debt markets. It all started when Franklin Templeton closed six yield-oriented debt mutual funds. Investors were risk-apprehensive as a result of this, resulting in enormous withdrawals from credit risk funds. The Reserve Bank of India (RBI) then injected liquidity and aggressively lowered interest rates to counteract the pandemiccaused slowdown, and long-duration and gilt funds revelled in the festivities. Rising bond rates have recently resulted in mark-to-market losses in Debt Funds.

Changing tactics to benefit from the debt markets heightened the outcry. You may have come across lingo such as barbell strategy, carry, roll-down strategy, and so on. Investing in dynamic bonds to ride out a variable interest rate scenario became popular last year. Investing in target maturity funds appears to have been the rage recently. All of this has certainly perplexed the common debt investor, who just seeks capital security and somewhat better yields than bank deposits. We want to simplify things for you and give you what you need to know through this article.

One thing is evident from the start: as an investor, you should not have to adjust your plan in response to changing market conditions. This is particularly true for debt fund investors. Whether you invest in stock or debt funds, your investing plan should be able to withstand market ups and downs. Debt mutual funds have come a long way since November 2012 when their assets under management (AUM) stood at ₹5.7 lakh crore. As of November 2022, it manages assets of ₹12.79 lakh crore, a rise of 124 per cent over the previous 10 years. However, it has been declining since March 2020.

Furthermore, debt mutual funds have underperformed on a year-to-date (YTD) basis. The median YTD returns of nine debt fund categories are less than the savings bank interest rate. In fact, in terms of median YTD returns, liquid funds have outperformed other debt fund categories. This is quite likely due to the increasing interest rate scenario.

Understanding Debt Funds
Debt funds invest in fixed income assets such as treasury bills, corporate bonds, commercial papers, government securities and a wide range of other money market instruments. All of these products have a predetermined maturity date and interest rate that the buyer can receive when the instrument matures. Fixed income securities’ returns are often less volatile than stock returns. As a result, debt funds are regarded as low-risk investment vehicles.

Working of Debt Funds Debt funds invest in a wide range of assets depending on credit ratings. The credit rating of a security indicates the risk of default in distributing the returns guaranteed by the debt instrument issuer. A debt fund’s fund manager makes certain that it invests in high-quality credit securities. A better credit rating indicates that the organisation is more likely to pay interest on the debt security on a regular basis as well as repay the principal when it matures.

Debt funds that invest in higher-rated assets are less volatile than debt funds that invest in lower-rated securities. Furthermore, maturity is affected by the fund manager’s investment strategy as well as the general interest rate regime in the economy. A low interest rate environment encourages fund managers to invest in long-term securities. A rising interest rate environment, on the other hand, stimulates investors to invest in short-term assets.

Target Audience
Debt funds strive to optimise returns by investing across all debt instruments. This enables debt funds to generate reasonable returns. Debt fund returns are predictable, however, are not assured. As a result, they are more secure options for conservative investors. They are also appropriate for investors with both short and medium-term investment horizons. The short-term spans three months to one year whereas the medium-term spans 3-5 years.

Short-Term Investor — Debt funds, such as liquid funds, may be a better investment for a short-term investor than holding money in a savings account. Liquid funds provide greater yields in the range of 7-9 per cent, along with higher liquidity to fulfil emergency needs.

Medium-Term Investor — An actively managed portfolio of debt funds is suitable for riding interest rate volatility for a medium-term investor. Actively managed portfolio of debt funds outperforms five-year bank fixed deposits (FDs) in terms of returns. Debt funds are great for risk-averse investors since they invest in securities that pay a fixed rate of interest and return the principal invested in full upon maturity.

Types of Debt Funds
There are several types of debt mutual funds available to meet the demands of a wide range of investors. The maturity term of the securities in which debt funds invest is the major distinguishing feature. The following are the various types of debt funds:

Overnight Funds — Overnight debt funds are investment schemes that invest in debt instruments with a one-day maturity. They are ideal for investors looking to lodge their assets for a limited time. These, like savings bank accounts, are typically regarded as highly secure investments.

Liquid Funds —Liquid funds invest in debt instruments having maturities of up to 91 days, such as treasury bills and commercial papers. They often invest in high-quality debt instruments with short maturities. While the risk is minimal, the yields are likewise modest.

Ultra-Short Duration Funds — Ultra-short duration funds invest in debt assets with Macaulay durations ranging from 3-6 months. They often generate higher yields than FDs.

Low Duration Funds — Low duration funds engage in financial assets having maturities ranging from 6-12 months. These funds are regarded significantly riskier than ultra-short duration funds due to their slightly longer duration.

Money Market Funds —These are open-ended funds that invest in money market securities having maturities of up to a year, such as cash, treasury bills and commercial papers.

Short Duration Funds —Short duration funds invest in debt instruments with Macaulay durations ranging from 1-3 years. This implies they can invest in both short-term instruments and other securities such as government bonds and debentures, corporate bonds, etc.

Medium Duration Funds — These debt funds invest in debt securities with Macaulay durations ranging from 3-4 years. 

Medium to Long Duration Funds — Debt instruments having Macaulay duration of 4-7 years are invested in by medium to long duration debt schemes. These funds entail a significant interest rate risk, but they might be an excellent choice in a declining interest rate environment. Interest rate risk means that an increase in the interest rates may lower the price of a fixed income security. Bond prices decline as interest rates rise, and vice versa.

Long Duration Funds — Long duration funds are debt funds that invest in debt securities with Macaulay duration of more than seven years. Because these funds invest in longer-term securities, they are riskier than the other funds discussed above. Despite this, long-term debt funds are seen as less risky than equity funds.

Dynamic Bond Funds — Dynamic bond funds can invest in debt instruments of varying maturities. Fund managers invest in accordance with the market’s current interest rate cycle. For example, if a fund manager expects interest rates to decline, he may invest in a long duration portfolio. However, if the interest cycle reverses, the fund portfolio may be adjusted to short duration.

Corporate Bond Funds — While all of the funds described so far invest primarily based on the duration of debt instruments, corporate bond funds invest primarily based on the credit rating of the assets. These funds invest at least 80 per cent of their assets in the highest-rated corporate bonds. When compared to other debt funds, they provide both safety and strong returns. 

Credit Risk Funds — Corporate bonds are also held by credit risk funds. However, these funds invest at least 65 per cent of the total fund assets in corporate bonds rated below investment grade. Because their credit ratings are lower, these bonds pay a higher interest rate to compensate for the credit risk. These funds are not suitable for conservative investors. The chance that a debt security issuer would default or fail to make a payment is referred to as credit risk. The greater the likelihood of lender default, the greater the credit risk of the instrument. The highest credit rating is AAA, which means they are the safest.

Banking and PSU Funds — These funds invest at least 80 per cent of the total fund assets in debt securities issued by banks, public sector undertakings (PSUs) and public financial institutions.

Gilt Funds — These are debt funds that invest at least 80 per cent of their fund capital in government securities with varying maturities. The default risk with gilt funds is low, but the interest rate risk is considerable.

Gilt Funds with 10-Year Constant Duration — These debt schemes invest at least 80 per cent of their fund assets in government securities with a 10-year fixed maturity. Because of the constant duration, the interest rate risk of these funds is fairly consistent.

Floater Funds — Floater funds invest at least 65 per cent of their assets in floating rate securities. A fixed coupon is not paid by floating rate instruments. Their coupon rate is instead linked to a benchmark. The RBI’s floating rate savings bonds, for example, are tied to National Savings Certificate (NSC) rates, which are reviewed quarterly 

Important Guidelines
There are certain things you must consider before investing in debt funds:

Risk
Debt funds are riskier than bank FDs due to credit risk and interest rate risk. In credit risk, the fund manager may invest in assets with poor credit rating so that there is a higher possibility of default. Bond prices may decline due to a rise in interest rates in interest rate risk.

Return
Even while debt funds are safe havens for fixed income investors, they do not provide assured returns. A debt fund’s net asset value (NAV) tends to decline when general interest rates in the economy rise. As a result, they are appropriate for a declining interest rate environment.

Expense Ratio
An expense ratio is a cost charged by debt fund managers for managing your money. The Securities and Exchange Board of India (SEBI) has mandated that the maximum expense ratio should be no more than 2.25 per cent of the total assets. Given the lower returns provided by debt funds versus equity funds, a long-term holding period would aid in recouping the money lost due to expense ratio.

Investment Horizon
If you have a three-month to one-year investing horizon, liquid funds are a good choice. Short-term bond funds, on the other hand, typically have tenures of 2-3 years. Dynamic bond funds would be good for an intermediate horizon of 3-5 years. In general, it makes sense to invest based on the investment horizon of your financial goals.

Financial Goals
You can utilise loan funds as an additional source of revenue to augment your salary. In addition, new investors might put some money into debt funds for liquidity. To get a pension, retirees may deposit the majority of their retirement corpus in debt funds.

Taxation on Debt Mutual Funds
Dividends paid by all types of mutual funds are taxed in the classic manner. They are added to your total income and taxed at your marginal tax rate. The tax on capital gains from debt funds is determined by the holding period. If the holding period is less than three years, such gains are referred to as short-term capital gains. These gains are added to your income and taxed as per the investor’s tax bracket. Long-term capital gains are gains realised after a three-year holding period. The gains are taxed at 20 per cent with indexation benefits.

Conclusion
Investing in debt mutual funds is not as straightforward as investing in equities. There are a lot of factors involved when you invest in a debt mutual fund, as explained above. Therefore, as a debt mutual fund investor, you should have great clarity about your investment horizon, risk appetite and investment objectives.