Spruce Up Your Portfolio With Debt Funds
![]()
One of the hallmarks of the Indian mutual fund industry’s growth has been the introduction of products that not only allow investors to invest in different asset classes such as equity, debt and gold, but also meet their requirements based on their risk profile and time horizon.
Considering that equity is an asset class that requires a long-term investment commitment across the board, the differentiation comes from the fund manager’s investment philosophy, the portfolio mix (i.e. stocks belonging to different market caps such Large-Cap, Mid-Cap and Small-Cap) as well as the investment strategy.
On the other hand, the major differentiator between different types of debt funds is the maturity duration of their portfolios. Debt funds invest in debt securities like corporate and PSU bonds, money market instruments and government securities. However, the level of exposure to these debt instruments depends upon the intended maturity duration of each of the fund categories.
As is evident, investors can have a diversified portfolio of debt securities through a single investment. If the right fund is chosen based on one’s time horizon and risk appetite, debt funds have the potential to provide better returns than traditional options like fixed deposits, bonds and debentures.
However, in their pursuit of earning higher returns, debt fund investors may have to face volatility from time to time. The performance of debt funds is impacted either positively or negatively due to an inverse relationship between the interest rate and bond prices. For example, while a set of funds like short-term as well as medium and long-term income funds benefit from falling interest rates, Fixed Maturity Plans (FMPs) provide opportunities to lock-in money for a fixed period at higher interest rates.
Debt funds also offer options such as dividend payout, dividend reinvestment and growth to allow investors to get the returns in a manner that suits their needs. Since debt funds invest in interest bearing securities, they are able to pre-set the frequency for dividend payout like daily, monthly, quarterly and half-yearly. Investors must choose the option carefully as this can have a significant impact on the taxes as well as on the corpus that they can expect to build over time. For example, those investors who wish to invest for the longer term must opt for the ‘growth option’.
Another major advantage of investing in debt funds is their tax efficiency compared to traditional options like FDs and bonds. For example, for a debt fund investor, long-term capital gains, i.e. any gains on investment redeemed after 12 months, are taxed at a concessional rate of 10 per cent and at 20 per cent if indexation is claimed. As is evident, investors in the higher tax bracket can benefit immensely from lower capital gains tax.
Under the dividend option, while the fund has to pay a dividend distribution tax of 28.3250 per cent for individual investors, it is tax-free in the hands of investors. Short-term capital gains, i.e. any gains on investments redeemed before 12 months, is taxed at the applicable tax rate, i.e. 10 per cent, 20 per cent or 30 per cent.
Choices Galore
Mutual fund houses offer a variety of debt funds. This allows investors to build a portfolio of debt funds to suit their risk profile and time horizon. Here is a synopsis of different types of debt funds and who should invest in them:
Liquid Funds
Liquid funds invest in securities with a residual maturity of not more than 91 days. Investments are mostly made in money market instruments.
These funds are suitable for investors who intend to park money for a short period, i.e. from a few days to a few months, and hope to earn returns better than those from savings bank accounts.
Ultra Short-Term Income Funds
Ultra short-term income funds are positioned between a liquid fund and a short-term income fund. These funds seek to provide a high degree of liquidity along with generation of reasonable returns by investing in a portfolio consisting of short-term debt and money market instruments.
These funds are suitable for investors who wish to invest for a period of around three to six months and seek to earn higher returns than liquid funds without compromising on a higher level of liquidity.
Short-Term Income Funds
Short-term income funds primarily invest in various debt instruments like government and corporate bonds, securitised debt and money market instruments. They normally maintain the maturity of the portfolio between one to two years.
These funds are suitable for investors with a short to medium-term investment horizon of six to 12 months and medium risk appetite.
Fixed Maturity Plans
Fixed Maturity Plans (FMPs) are closed-ended funds that have a fixed maturity date and mature like a fixed deposit at the end of that period. Under an FMP, the fund manager invests in fixed income instruments like bonds, government securities and money market instruments. The key here is that the fund manager invests in those instruments that will mature around the time of maturity of the plan. This strategy eliminates the volatility risk.
These are ideal products in a higher interest rate scenario as the fund manager can lock-in investments at higher yields, thereby providing higher returns to investors.
Income Funds
Income funds invest in various debt instruments like government and corporate bonds, securitised debt and money market instruments. However, these funds usually have a portfolio maturity duration that is much longer than that of short-term income funds.
Income funds are suitable for investors who intend to invest with a time horizon of at least 12 months and have the appetite to face higher volatility to get higher yields.
The income fund category has variants like duration funds, dynamic funds and accrual funds. It is important for investors to understand the distinction between these categories so that they can invest in the right fund as per their requirement.
As there is an inverse relationship between interest rates and bond prices, these funds typically keep their portfolio maturity duration at around six to seven years so as to benefit from the falling interest rates. Hence, these funds do very well during a softening interest regime. However, as duration funds tend to be quite volatile, it is equally important for investors to keep an eye on the emerging interest rate scenario so as to work out their exit strategy.
These funds aim to generate income and long-term gains by investing in a range of debt and money market instruments of various maturities. The fund manager of a dynamic bond fund has the flexibility of managing the duration of the portfolio to optimise the risk-return proportion.
These funds aim to take advantage of investment opportunities at the shorter end of the yield curve. While they have the potential to offer steady returns as compared to duration and dynamic bond funds, they can give investors a happy surprise in case of a steep fall in yields.
Where To Invest In The Current Scenario?
The last 15-18 months have been a mixed bag for debt fund investors. For a year or so up to June 2013, debt funds performed well as the benchmark 10 year GoI yield spiralled downward. However, the debt market turned volatile when the RBI failed to cut the rates in its June 2013 credit policy despite a fall in WPI inflation. The US Fed’s decision to roll back its USD 85 billion bond purchases also created panic in debt markets across the globe.
It is little wonder then that the last couple of months have been difficult for debt fund investors. After seeing a fantastic run for over a year, all categories of income funds including liquid as well as ultra short-term income funds posted negative returns. The situation worsened as the rupee touched an all-time low vis-a-vis the USD.
The RBI swung into action and fixed the borrowing limit of banks to one per cent of the system’s net demand and time liability or the banks’ total deposit base w.e.f. July 17, 2013. Besides, the Marginal Standing Facility (MSF) rate and the bank rate were raised by 200 basis points to 10.25 per cent.
These steps had an immediate and serious impact on the debt markets. The yield on the 10-year benchmark rose to 9.48 per cent from the previous level of 7.14 per cent. Consequently, the NAVs of all types of debt funds were negatively impacted. The most impacted were those who invested in income funds a couple of quarters ago in the hope that the debt market rally will continue. On the positive side, however, investors also got an opportunity to lock-in their money at higher yields through FMPs.
Volatility in the debt market continued even after the US Federal Reserve decided not to pull back on bond purchases as the RBI, in its September monetary policy review, increased the repo rate by 25 basis points from 7.25 per cent to 7.50 per cent with immediate effect. However, the central bank reduced the MSF rate by 75 basis points from 10.25 per cent to 9.50 per cent. Besides, the minimum daily maintenance of CRR was reduced from 99 per cent of the requirement to 95 per cent effective from the fortnight beginning September 21, 2013.
The current scenario continues to provide investors an opportunity to lock-in money at attractive yields through FMPs. However, considering that liquidity provided through listing on the exchanges under FMPs is not really effective, you must be sure about your time horizon.
For those investors who may not like to lock-in money, short-term as well as income funds following an accrual strategy can be good options. Considering that the yield to maturity (YTM) for these categories of funds is currently quite high, investors can expect healthy returns. Investors with some risk appetite can also consider investing a small part of their portfolio in dynamically managed bond funds.
Hemant Rustagi
CEO, Wiseinvest Advisors