Debt Market in India is mostly unknown to Retail Investor. Let's understand the Debt Funds with following points.
> How Debt works?
> Types of Debt Funds available in Indian Market
> Risk associated with Debt Funds
> Important terms of Debt Funds
> Selection process for Debt Fund
What are Debt Funds?
Debt funds invest in securities which generate fixed income like treasury bills, corporate bonds, commercial papers, government securities, and many other money market instruments.
All these instruments have a pre-decided maturity date and interest rate that the buyer can earn on maturity – hence the name fixed-income securities.
The returns are usually not affected by fluctuations in the equity market. Therefore, debt securities are considered to be low-risk investment options.
How Debt Funds works?
Debt funds invest in either listed or unlisted debt instruments, such as bonds or corporate debt securities at a certain price and later sell them at a margin. The difference between the cost and sale price accounts for the appreciation or depreciation in the fund’s net asset value (NAV).
A debt scheme’s NAV depends on the interest rates of its underlying assets and also on any upgrade or downgrade in the credit rating of its holdings. Market prices of debt securities change with movements in interest rates.
Let’s assume, your debt fund owns a security that yields 10 per cent interest. If the interest rate in the economy falls, new instruments that hit the market would offer this lower rate. To match this lower rate, there would be an increase in your fund’s instrument prices as they have a higher coupon rate. As a result of the increase in the debt instrument’s value, your fund’s NAV, too, would increase.
In terms of return, debt funds that earn regular interest from the fixed income paper during the fund’s tenure are similar to bank fixed deposits that earn interest. This income gets added to a debt fund on a daily basis. If the interest comes, say, once a year, it is divided by 365 and the debt fund’s NAV goes up daily by this small amount.
Types of Debt Funds available in Indian Market
Let’s have a look at the different categories of debt funds. The table below shows the features and suitability of different Debt Fund category:
The risk associated with Debt Funds
Credit Risk – which is the default risk of the issuer not repaying the principal and interest. The NAV of debt funds fluctuates with changes in the credit rating. If the credit rating improves, then the NAV of a debt fund improves and vice versa. Government securities have almost no default risk.
Interest Rate Risk – which is the effect of changing interest rates on the value of the scheme’s securities. The NAV of debt funds fluctuates with changes in the interest rate. If the interest rates rise, then the NAV of a debt fund falls and vice versa.
Liquidity Risk – which is the risk carried by the fund house of not having adequate liquidity to meet redemption requests.
Debt funds offer lower returns as compared to equity funds. Also, there is no guarantee of the returns.
Important terms of Debt Funds to know
Average Maturity: A debt fund the portfolio comprises several bonds with varying maturity dates. Average maturity is the weighted average of maturity for all bonds in the fund portfolio.
Modified Duration: The duration is the measure of price sensitivity of the portfolio to change in interest rates. For instance, if interest rates go down (or up) by 1% in a month, the NAV of the fund will go up (or down) by 4% if the modified duration is four years.
Yield to Maturity (YTM): The Yield to Maturity (YTM) is what the bond will earn from its coupon payments as well as annualised gain (or loss) on the purchase price if held till its maturity.
Yield Curve:
The yield curve is a chart consisting of the yields of bonds of the same quality but different maturities. This is used as a measure to assess the future of interest rates. Here, the time value is plotted on the X-axis and yields on the Y-axis. The curve graphically demonstrates the rate at which market participants are willing to transact debt capital for the short term, medium-term and long term. The yield curve is positive when long-term rates are higher than short-term rates; however, the yield curve is sometimes negative or inverted.
Types of Yield Curves:
Steep Yield Curve/Upward Sloping Curve:
This curve is normally observed at the beginning of an economic expansion or just at the end of a recession. The slope of the yield curve increases as the difference between long-term yields and short-term yields become wider. The inherent assumption behind such a curve could be that while short-term economic conditions warrant lower rates, factors like inflation, etc. could rise in the medium/long-term justifying much higher long-term rates.
Flat Yield Curve
When there is no change in the market outlook on interest rates, we get a flat yield curve. This is because yields are almost the same across tenors.
Inverted Yield Curve
When short-term interest rates are higher than long-term interest rates the shape of yield curve takes downward sloping. This happens when markets expect high volatility in the near future however long-term story remains the same.
Selection process for Debt Fund
Step 1 – Selection of Debt Fund Category based Yield Curve (Interest Risk):
|
Yield Curve Type |
Recommended Debt Fund |
|
Steep / Upward Sloping Curve |
Medium / Long Duration Funds |
|
Flat Curve |
Short Duration Funds |
|
Inverted Curve |
Ultra-Short / Short Duration Funds |
The investor must select the category of Fund based on the yield curve to minimise the interest risk arising out of Debt Funds.
·
Step 2 – Selection of Fund based on Health
report (Credit Risk):
Select Fund based on Low Credit Risk:
Funds with a portfolio of A1+ rated papers, AAA-rated bonds and Sovereign bonds should be preferred as this type of portfolio offers the lowest risk among peers.
Also, it is important to check the credit the outlook of underlying papers and bonds to analyse the Credit Risk of any Fund.
With Step 1 and Step 2, one can minimise the interest risk and credit risk arising out of Debt Fund and select suitable scheme for their investment.
Debt Funds vs Fixed Deposits
Let’s have a look at the differences between fixed deposits and debt funds. The tables below help you decide which investment is suitable for you.
Generally, debt funds have offered better returns than fixed deposits in the past. From the tax point of view, debt funds could be a better choice, especially if you hold them over the long term.
Ultimately, you should weigh your the decision on your risk appetite, income tax slab, time horizon, and investment goals.
We hope that the above points have clarified your most of queries related to Debt Funds.
Conclusion
When equity markets are on a high, debt funds are usually the last thing on the mind of investors. What investors are usually unaware of is that debt funds are the best way to counter the equity market volatility. If a careful choice is made across debt fund categories keeping in mind one's overall investment objectives, debt funds can offer the benefits of capital appreciation and yield reasonable returns over a period of time.
We at Mota Investments, try to choose one of the best Debt Fund scheme based on Credit Risk and Interest Risk criteria along with Investor’s investment horizon and risk appetite.
