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Debt Funds – Fixed Income With No Risks?

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Debt Funds India

By: Tavaga Research

The market is saturated with debt instruments more so than equity instruments in terms of the market value of assets. Despite such a widespread presence, fixed-income securities or debt securities seem like uncharted territory for most investors. Debt Funds enable a retail investor to invest and gain exposure to the debt market.

Typically, debt funds are considered low-risk, but does that allow an investor to invest and forget? The article deliberates on the various factors surrounding debt funds.

Before diving into debt funds, let us establish the meaning of debt securities. Corporations raise capital through either equity or debt. Debt or fixed-income instruments provide returns in the form of fixed regular interest payments and principal payment (at the end of the maturity). An investor in debt security is essentially lending money to the company that is issuing the debt instrument for raising finance.

Government securities, treasury bills, corporate bonds, commercial papers, and other money market instruments are popular fixed-income securities.

Debt Funds definition

Debt Funds are pooled investment vehicles, such as a mutual fund or an exchange-traded fund. Pooled investment funds create a pool of funds collected from investors and deploy the pool toward various securities across sectors. Therefore, a debt fund comprises fixed-income securities as its holdings.

Debt Funds Meaning

Based on the theme of the fund, a fund may be comprised of short-term or long-term securities, and investment-grade or junk grade securities. Debt funds are sought by investors who look for portfolio diversification. Funds from this category also provide regular income in the form of coupon payments.

Debt funds also charge a lower expense ratio as compared to equity funds owing to lower management fees. Management fees are lower as there is less frequent churning of the fund portfolio.

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Debt Funds Types

The two main variables while investing in debt funds are maturity and credit quality of the underlying debt securities. Debt funds can be broadly categorized in the following ways:

  1. Liquid Funds: Liquid Funds invest in money market instruments, which have maturities ranging from one to 91 days. The focus of such a fund is to facilitate liquidity while keeping the risk at the bare minimum. Therefore, liquid funds prioritize safety over returns generated. Liquid funds are generally used to park an investor’s money while waiting for a lucrative investment opportunity.
  2. Gilt Funds: Gilt Funds invest in fixed-income securities issued by the Central or State Governments. Since the securities are backed by the Government, the gilt securities essentially have negligible default risk. The Government securities do carry interest rate risk as they are issued for longer maturities. Gilt funds thrive in low-interest-rate environments.
  3. Money Market Funds: This category of debt fund deals in short-term securities. For money market mutual funds, the maturity period ranges from one day to one year.
  4. Income Funds: Income funds focus on generating income from the securities. Income funds primarily invest in fixed-income securities servicing high coupon payments; such securities generally have longer maturities.
  5. Dynamic Bond Funds: Dynamic Bonds are managed actively with the fund manager taking active calls based on interest rate forecasts. Dynamic Bond funds invest across maturities. Dynamic Bond funds are open-ended schemes.
  6. Short-term and Ultra Short-term Debt Funds: Shorter maturities have a low factor of interest rate risk making short-term funds ideal for conservative investors.
  7. Floater Funds: Floater funds invest most of the investment corpus in fixed-income securities offering floating rate of coupons. Therefore, the coupon payments fall in line with the interest rates prevalent in the economy.
  8. Credit Risk Funds: Credit Risk funds try to take advantage of the differences in the credit risk of various securities. By investing in lower-rated bonds, the fund tries to yield higher returns. Due to credit risk present in the funds, the risk factor is higher.
  9. Fixed Maturity Plans (FMPs): FMPs are close-ended funds and invest for a fixed maturity. An investor entering at the time of fund offering has to abide by the lock-in period. FMPs typically invest in high-rated debt instruments to maintain the safety of the investment.

Debt Fund Returns

Top Debt Funds – What are good debt funds?

Fund Name 1-Year Return 3-Year Return
IDFC Constant Maturity Fund 13.85% 12.74
Nippon India Gilt Securities Fund 12.52% 10.68%
Nippon India Gilt ETF 11.02% 9.02%
SBI Magnum Medium Duration Fund 13.13% 9.95%
Kotak Dynamic Bond Fund 12.54% 10.33%

Debt Funds Taxation

Investors of debt funds can earn income by choosing either the growth option or dividend option. In the case of a dividend option, the earnings of a fund are distributed periodically. The growth option enables an investor to reinvest the accrued earnings from the fund to reap the benefits of compounding. The tax treatment differs under both options.

Dividend taxation: Dividends earned from debt funds are taxable in the hands of the investor. Dividend income is added to the total income of the individual and taxed as per the applicable tax slab rate. Earlier, Dividend Distribution Tax (DDT) for debt funds used to be 29.12 percent for debt funds. With DDT abolished, an investor stands to benefit if a lower tax slab rate is applicable.

Capital gains taxation: Capital Gains are taxed differently for short-term (STCG) and long-term capital gains (LTCG). The threshold is 36 months. In the debt fund category, a capital gain that is made beyond 36 months is considered as long term capital gains and if the holding tenure is less than 36 months, it is a short term capital gain.

  • STCG is added to the investor’s income and taxed as per the applicable slab rate
  • LTCG is taxed at 20 percent with indexation benefits and 3 percent surcharge is also added

Indexation Benefits Gains arising from a debt fund are calculated by subtracting the cost of purchase from the current market value of the units. STCG is calculated simply using the formula.

However, LTCG offers an indexation benefit. The cost of purchase is indexed to the present inflationary conditions in the economy. LTCG can reduce the tax liability of an investor. The gains arising over the long-term are not overstated by a reduction in the difference between the indexed cost of purchase and the current market value.

Debt Funds vs Equity Funds

As the name suggests, debt funds primarily invest in debt securities and equity funds invest in equity instruments of different companies.

Debt Funds vs Equity Funds
Source: Tavaga Research

Debt Funds vs Fixed Deposit

Debt funds and Fixed deposits are similar in that both the investment options offer fixed returns for assuming a relatively lower risk. However, an individual must be aware of the factors that can make a difference:

Debt Funds vs Fixed Deposits
Source: Tavaga Research

Are debt funds safe? – The risks of investing in Debt Funds

While debt funds are considered to be low-risk investments, various types of risks are still prevalent in such securities:

  1. Interest Rate Risk: Bond prices are inversely related to the interest rates. Bond prices fall as the interest rates rise and vice versa. Interest rates typically rise as the economy expands, which is why equities outperform debt in such conditions. Debt securities with higher maturities carry more interest rate risk than short-term securities. For example, gilt funds pose more interest rate risk than liquid funds.
  2. Credit rating of the company: Credit risk is the inherent risk of investing in debt funds. While the investor is aiming for higher returns, the risk should not be above the risk appetite. Credit rating is the measure of how financially secure the issuing company is. Credit rating entails the chances of the company defaulting on its obligations. Therefore, the investor should try to strike a balance between aiming for higher yield and highly rated companies. Debt securities below the investment grade offer return at the cost of assuming credit risk.
  3. Liquidity: A fund must be liquid to the extent that widespread redemptions do not impact the NAV of the fund.
  4. Concentration risk: A debt fund should be selected based on the diversification achieved by the fund. For example, a fund’s exposure to IL&FS is more than what is justified. As soon as IL&FS defaulted, the fund’s NAV would be solely impacted by the bond prices of IL&FS. Therefore, such a fund would give massive negative returns thereby destroying capital. A debt fund must spread the assets under management across various securities, gaining exposure to multiple factors.
Debt Funds - Risk vs Return Trade-Off
Source: Tavaga Research

Speaking of risks involved in debt funds, it seems customary to mention the Franklin Templeton debacle that recently surfaced. Franklin Templeton AMC had large scale exposure to companies that defaulted on their debt obligations. As a result of such defaults, the AMC had to shut some of their debt schemes. The debt schemes faced a massive single-day fall in their NAVs on the announcement. The closure of schemes, even though voluntary, was based on illiquidity in the markets. Illiquidity also built up redemptions pressure as the fund could not process the redemption requests of the unitholders.

Investment in debt funds has to be as per the investment goals of an individual as this category offers a wide range of instruments (ranging from 1 day to 10 years). While it is true that debt funds offer many risk-free investment options for an investor to choose from, it is highly recommended to check the expense ratios of all these risk-free funds. Gilt ETF is one of the instruments that offer a relatively lower expense ratio with higher returns in a low-interest rate regime.

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