MF Maze To Matrix

FUND FLAVOUR

December 2018

The What, Why, Who and How of Debt Funds…

What?

Debt Funds are those which allocate investors’ money in fixed-income earning instruments i.e. treasury bills, corporate bonds, government securities, commercial paper and other money market instruments. The main objective to invest in a debt fund is to accumulate wealth by means of interest income and steady appreciation of the fund value. The underlying securities generate interest at a fixed rate throughout the tenure for which you stay invested in the fund.  The fund manager of a debt fund invests in the underlying securities on the basis of their respective credit ratings. A higher credit rating indicates that a debt security has a higher chance of paying interest regularly along with repayment of the principal upon expiry of tenure. Apart from that, the fund manager aligns his investment strategy according to the overall interest rate movements.

 Some misconceptions regarding Debt Funds

  • Debt funds are very risky:

Just because debt funds underperformed FDs when equity gave fantastic returns, does not mean that debt funds are as risky as equity. In a bad bear market, equity funds can fall 20% or more. Even in a bad year for bond market like 2017, debt funds were able to generate positive returns. Debt funds are much less risky than equity funds. Further, many debt fund managers employ a flexible investment strategy to safeguard investor interests in different debt market conditions.

  • Short term debt funds have no interest rate risk:

Any debt fund whose, maturity profile is more than a year, will be subject to interest rate risk. As such, even short term debt funds have interest rate sensitivity. However, the interest rate risk is limited compared to long term debt funds.

  • There is no risk in debt funds if RBI keeps rates unchanged:

Bond yields can change even if RBI keeps rates unchanged. Investors should understand that the Government is the biggest borrower. If the Government of India needs to borrow more to meet its different obligations towards the economy, then bond yields will go higher, bond prices will fall and consequently, debt funds will give lower returns. In an increasingly globalized economy, bond yields in India also depend on bond yields in developed markets like the US. If US bond yields are increasing, then foreign investors are likely to shift their investment from emerging markets to the US Treasury Bonds, which is a much safer asset for them. Similarly, if the dollar is strengthening versus emerging market currencies, foreign investors will divert their funds to the US. To attract foreign investments, Indian bond yields have to rise and this may hurt existing bond investors.

  • Long term debt funds need market timing:

It is true that, if you time your long term debt fund investments at the top of the interest rate cycle, you can get excellent returns. However, market timing is not a necessary condition to get good returns from long term debt funds. The yield curve is usually upward sloping, which means that long term bonds give higher yields than short term bonds. If you have a long investment horizon then, you can benefit from the higher yield over long investment tenure and also from the fact that, over a long investment tenure interest rate or yield cycles reverse, meaning that you will have periods of both rising rates and falling rates. So while rising rates will cause prices to depreciate, falling rates will cause prices to appreciate.

  • Long term debt funds will always outperform short term debt funds in the long term:

For some debt fund investors this may come as a surprise, but long term debt funds do not always outperform short term debt funds in the long term. The definition of long term can be quite subjective and vary from investor to investor. From a debt fund perspective, let us assume that, 3 to 5 years investment tenure is long term. In the last 3 years, short term debt funds gave 7.9% annualized returns while long term debt funds gave 7.4% annualized returns; in the last 5 years, short term debt funds gave 8.3% annualized returns while long term debt funds gave 8% annualized returns. Over both time-scales, short term debt funds outperformed long term debt funds by varying margins. Over very long term, the relative performances of short term and long term debt funds actually evens out, with no significant advantage to either category.

Why?

Debt funds are chosen by those who are looking for steady income with relatively lower risks, as it is comparatively less volatile than equities. In other words, debt funds are more preferred than equities because the risk is low. Debt funds are preferred by individuals who are not willing to invest in a highly volatile equity market. Debt mutual funds also help to provide tax efficient regular cash flows via systematic withdrawal plans or SWPs. Since these funds invest in fixed income securities, debt funds offer better safety on long term basis along with better returns. Debt funds are a vital component of a well-diversified portfolio as their returns are typically more stable (less volatile) than equity funds. Thus, diversifying nature of debt funds reduces the overall portfolio risk.

Who?

Debt funds are chosen by investors who are conservative and who do not wish to take exposure to the equity market. They want to grow their wealth but in a less volatile manner. Additionally, they would be concerned about regular income as well. Investors usually stay invested in debt funds for a short-term and medium-term horizon. You need to choose an appropriate debt fund according to your investment horizon. Liquid funds may be suitable for a short-term investor who usually keeps his surplus funds in a saving bank account. Liquid funds will provide higher returns in the range of 7%-9% in addition to the flexibility of withdrawals at any time just like a saving bank account. If you need to ride the interest rate volatility, then dynamic bond funds may be an ideal option. These funds are suitable for a medium-term investment horizon to earn higher returns as compared to 5-year bank FD.

How?

How to evaluate Debt Funds?

Fund Objectives

Debt Fund aims to earn optimal returns by maintaining a diversified portfolio of various types of securities. You can expect them to perform in a predictable manner. It is because of this reason, that debt funds are popular among conservative investors.

Fund Types

Debt funds are further divided into various categories like liquid funds, monthly income plans (MIPs),  Fixed Maturity Plans (FMPs),Dynamic bond funds, income funds, credit opportunities funds, GILT funds, short-term funds and ultra-short-term funds.

Risks

Debt funds are basically exposed to interest rate risk, credit risk, and liquidity risk. The fund value may fluctuate due to the overall interest rate movements. There is a risk of default in the payment of interest and principal by the issuer. Liquidity risk happens when the fund manager is unable to sell the underlying security due to lack of demand.

Cost

Debt funds charge an expense ratio to manage your money. Till now SEBI had mandated the upper limit of expense ratio to be 2.25%.

Investment Horizon

An investment of 3 months to 1 year would be ideal for liquid funds. If you have a longer horizon of say 2 to 3 years, you may go for short-term bond funds.

Financial Goals

Debt funds can be used to achieve a variety of goals like earning additional income or for the purpose of liquidity.

Fund returns

You need to look for consistent returns over long-term say 3, 5 and 10 years. Choose funds which have outperformed their benchmark and peer funds in a consistent manner across different time frames. However, remember to analyze the fund performance which matches your investment horizon to get relevant results.

Fund history

Choose fund houses which have a strong history of consistent performance in the investment domain. Ensure that they have the consistent track record for at least say 5 to 10 years.

Expense ratio

It shows how much of your invested amount is being used to manage expenses of the fund. A lower expense ratio means higher take-home returns. Choose a fund with a lower expense ratio which can give you superior performance.

Taxation

Currently, the minimum tenure for long-term capital gains (LTCG) has been extended from one to three years. This means that investors will have to remain invested for at least three years in debt funds if they want the benefit of lower tax on long-term capital gains. If redeemed/used within three years or lesser i.e. short-term capital gains (STCG), the gains will be added to the person’s income and taxed as per the applicable income tax slab structure. However, if the investor can hold for more than three years i.e. LTCG, a debt fund will be taxed at 20% after indexation. Indexation (it allows you to inflate the purchase price using cost Inflation Index) takes into account inflation during the period that the investment is held by investor and accordingly adjusts the purchasing price which can lower the capital gains tax significantly. Another tax-friendly feature of debt funds is that there is no tax deduction at source (TDS) on the gains.

Financial ratios

You can use financial ratios like standard deviation, Sharpe ratio, alpha and beta to analyze a fund. A fund having, higher standard deviation, and beta are riskier than a fund with lower beta and standard deviation. Funds with a higher Sharpe ratio means it gives higher returns on every additional unit of risk taken.

Modified Duration and Volatility

In fixed income (debt) investing, primarily two types of investment strategies are deployed.

Hold till Maturity

This is also known as accrual strategy, by which the fund invests in certain types of fixed income securities (or bonds) and holds them till maturity of the bond, earning the interest offered by the bond over the maturity period.

Duration Calls

Using this strategy the fund manager, takes a view on the trajectory of interest rates. Bond prices go up when interest rate falls and declines when interest rate goes up. Why? Suppose you bought a 20 year bond with a coupon (interest) of 9% at face value of Rs 100 a year back. If interest rate goes down by 1% during the year then bond yields will decline; in other words, new bond issuers will offer lower coupon (interest) rates. Since your 20 year bond will pay you higher interest rates than what current yields are, investors who wish to earn the higher interest rate, will be ready to pay more than Rs 100 for your 20 year 9% coupon bond. You can sell your bond which you bought at a face value of Rs 100 at a higher price and earn a profit, over and above the coupon payment you received in the last one year. Long term debt funds like Long Term Gilt Funds, Income Funds and Dynamic Bond Funds etc are examples of debt funds which take duration calls based on interest rate expectations.

Performance

Many income funds are showing double-digit annualised one-month returns as high as 57%. Indiabulls Income Fund has offered the highest annualised returns of 57%, followed by ICICI Prudential Income Fund (51.66%) and Reliance Income Fund (44%). The high returns are due to a sharp fall in the government securities’ yields in the last one month. Benchmark 10-year G-Sec yields have fallen because of the change in borrowing plan by the government and the RBI surprisingly cutting its inflation forecast. The central government has announced that it plans to complete around 47% of its borrowing in the first six months of the current financial year. The government generally completes around 60-62% of its targeted gross annual borrowing in first half of the year. The 10-year benchmark yield has fallen from 7.7%, in the beginning of March 2018 to 7.2% in beginning of April 2018, its lowest in four months. The inverse relationship between interest rates and bond prices is benefitting debt funds. Thus, debt schemes which were showing negative returns in January 2018 have turned green again. Income fund category is offering an average one-month annualised return of 22.48%.

Bond with the best

Debt mutual funds have products starting from Liquid funds with lesser than 91 days of maturity papers to Long-term gilt funds with 8-10 years maturity. Choice of funds depends on your objective and the average maturity of papers. If you need money after 1 year then there is no point being into a long-term gilt fund with 8 years of average maturity, as this might make your portfolio more volatile. Similarly, if your horizon is 10 years or more, then being in short-term papers sometimes may not make sense. Selecting the category of debt mutual funds first becomes crucial. Investing aggressively at the longer end of the yield curve could prove imprudent. To put it simply, investing in long-term debt fund (holding longer maturity debt papers) can be perilous, since most of the rally has been already captured at the longer end of the yield curve. In fact, short-term maturity papers are turning attractive and fund houses are aligning their portfolio accordingly too. Ideally, you will be better-off if you deployed your hard-earned money to short-term debt funds. But ensure you are giving due importance to your investment time horizon, asset allocation, and diversification. Consider investing in short-term debt funds for an investment horizon of up to two years. If you have an investment horizon of 3 to 6 months, ultra-short term funds (also known as liquid plus funds) would be the most suitable. And if you have an extreme short-term time horizon (of less than 3 months), you would be better-off investing in liquid funds. Do not forget that investing in debt funds is not risk-free. Some other options to invest in debt instruments are tax-free bonds, especially, if you are in the highest tax-bracket. A few highly rated corporate deposits and bonds may also yield better returns than bank FDs. Ensure you study the company’s financials before investing, as the risk of default cannot be ignored. This will buffer you from any financial shock. Sensible and astute investment strategy serves the path to wealth creation and it is always beneficial for your long-term financial well-being.