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Debt Mutual Funds
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Indian Mutual Funds classify their schemes into three broad types: Equity, Debt and Hybrid / Balanced Funds.
In this session, we shall discuss about Debt Mutual Fund schemes.
A Debt Mutual Fund scheme is one where all or majority of its funds are put into Debt-asset class securities.
Some of the debt asset class securities are:
- Certificate of Deposit
- Commercial Paper
- Central Government Securities
- Bonds
- NCDs
- Securitised Debt Instruments
- CBLO / Reverse Repo Investments
Contents
Advantage of Debt Schemes
- Safer and less volatile over Equities
- More or less predictable returns
- Different securities depending on our period of holding
Disadvantage of Debt Schemes
- Tax in-efficient
- Not wealth maker in long term
- Barely beats inflation
Types of Debt Funds
According to SEBI reclassification in 2018, there are around 15 categories of debt funds
- Overnight
- Liquid
- Ultra Short term
- Low Duration
- Money Market
- Short Duration
- Medium Duration
- Medium to Long Duration
- Dynamic Bond
- Corporate Bond
- Credit Risk
- Banking & PSU
- Gilt
- Git with 10 year duration
- Floater
Debt Mutual Fund Risks
Here are some words accord to Warren Buffett in his Annual letters to shareholders in regard to the Bond market and risks associated (in the US context):
"Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. "Risk" is the possibility that this objective won’t be attained. By that standard, purportedly "risk-free" long-term bonds in 2012 were a far riskier investment than a longterm investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond. ...in any upcoming day, week or even year, stocks will be riskier – far riskier... As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates."
Degree of Risk
Many investors have the wrong perception that debt funds are absolutely safe .. Like bank fixed deposits.
This is absolutely wrong.. and it is wrong to compare with bank fixed deposits too.
Debt mutual funds are investments .. and all types of investments carry risks.
On the other hand, bank fixed deposits are savings deposit instruments and carry a bank guarantee for your deposit.
Perhaps, the volatility and degree of risk in debt funds will be far less compared to equity mutual funds.
Further, it is important to note that all debt funds are not the same.
A liquid or an ultra-short term, since have their assets invested in low duration security instruments, are safer compared to other debt fund types.
Of course, their returns too are limited .. mostly at around 9% in the present market circumstances.
Duration of investment
To have managed (if not reduced) risk, it is better to invest in an appropriate duration debt fund.
For instance, if you wish to invest for 3 months, an ultra-short would be better than a long-term debt fund.
Similarly, for an investment horizon of 1 year, a short-term debt fund would be better.
Direction of interest rate
Debt mutual funds closely are related to interest rates.
This is more true in the case of long-term debt funds.
In general, rising interest rates are not good news for debt funds.
On the other hand, falling interest rates are sweet news for debt funds.
Why is this so?
This is because of the inverse relationship between yields and prices of bonds.
When interest rates fall, the bond prices go up and it will boost NAVs of the debt mutual fund schemes.
When interest rates rise, thevalue of older, lower-interest bonds falls.
This means that the NAV of debt funds will fall giving temporary negative returns for the investors.
In another case, when there is an unanticipated volatility in the interest rates, the scheme NAVs will witness some turbulance.
The sharper and unanticipated the interest rate change, the more volatile will be the scheme NAV.
Credit quality
Another important factor to consider is the quality of the underlying debt securities.
In general, go for high quality debt instruments because the risk of a default or delayed payment will be less.
The recent Taurus Mutal Fund issue highlights the need for going for good credit quality debt schemes.
Similarly we have seen the impact of defaults and corporate bond rating downgrades in 2015 and 2016 where in funds having exposure to Amtek Auto and JSPL got hit.
Debt fund for 6 to 8 month investing
Question: Is there any exit load on ultra short term debt funds and liquid funds? Which one is better for 6-8 months duration?
Most Liquid funds do not have an exit load.
Most, if not all, Ultra Short term funds will not have an exit load. Even if they have, it will be usually for redemptions before 60/90 days.
Since you investment horizon is for 6 to 8 months, and if you are prepared to take some debt fund risks, you could try short term funds that do not have any exit load or those that have smaller exit load.
For instance, BOI AXA Short Term Income Fund is a good fund in this category and has a 180-day load.
Franklin India Low Duration Fund has a load for 90-days
Reliance Floating Rate Fund - Short Term Plan is another plan worth trying. It carries a load for 30-days.
If, however, you wish to invest in Liquid funds only, study Indiabulls Liquid Fund, JM High Liquidity Fund and Reliance Liquid Fund - Cash Plan
Some good funds in the Ultra-Short term pack are Baroda Pioneer Treasury Advantage Fund, Birla Sun Life Cash Manager and BOI AXA Treasury Advantage Fund.
Invest on your own from the AMC website under DIRECT plan - GROWTH option.
- Date: Feb 21, 2017
SEBI eases investment norms for debt funds
SEBI has allowed debt fund managers to execute imperfect hedging through interest rates futures (IRFs). This will help fund managers reduce interest rates risk in debt portfolios. Under imperfect hedging; fund managers do not necessarily hold a debt security in the portfolio to buy interest rate futures of that particular security. For example, fund managers can buy interest rates futures of a 10 year G Sec even without having exposure to 10 year G Sec in the underlying portfolio.
So far, fund managers could only hold interest rate futures of a security if they had the security in their underlying portfolio. Fund managers can now hold such imperfect hedged IRFs to up to 20% of net assets of the scheme.
Source: Wise Money dated 2 - 5 October 2017
How do Debt Mutual Funds handle a default?
In the securities market, technically speaking, any borrower other than the Government can default the payment of promise he has made.
This is exactly what has happened in the case of several debt mutual funds that had exposure to Amtek Auto, Bhallarpur, ILFS etc.
The default can happen with NCDs or Commercial paper etc.
Different types of schemes will have different methods of handling a default.
In most cases, MFs sell the defaulting papers in off market transaction at a paltry loss.
Some MFs hold the instrument with a hope and put it under "receivable" but might have to face a "write-off".
Ideally, MFs downgrade as soon as credit rating agencies (CRISIL and ICRA) downgrades.
Some Mutual Funds immediately write-off (as in the case of liquid funds) where the duration of the holding of the underlying securities has to be kept low.
It is not necessary that MFs write-off the default immediately. It gets another three months (that is, 6 months from the default date) to mark it down to 10%. Then another 3 months for another 20%. Then, in every three months after, 20%, 25% and 25%. The asset is written down to zero in 18 months.
What can we as investors do about this?
There are several things and it all depends on investor and his risk profile.
1. Investors can just stay invested and let the MF take the decision about it. There are several situations where the defaulted money did come back though there was an immediate panic.
2. Exit from the scheme. If you feel the fund has exposure to a company that defaulted, you may pro-actively exit from the scheme even before the MF handles the fire.
The best way to avoid these problems is to go with schemes that has diversified type of underlying debt instruments as well as having high AUM.
Other Information on Debt Funds
STT or Securities Transaction Tax is not applicable on debt or debt-oriented mutual fund (including liquid fund) units.
Related Topics
- Diversified Multicap Equity Funds
- Equity Linked Savings Schemes (ELSS)
- Equity Savings Mutual Funds
- Capital Protection-Oriented Funds
- Arbitrage Mutual Fund Schemes
- Exchange Traded Funds
- International Mutual Fund Schemes
- Largecap Mutual Fund Schemes
- Midcap Mutual Fund Schemes
- Smallcap Mutual Fund Schemes
- Thematic Mutual Fund Schemes
- Dynamic Bond Funds
- Dynamic Asset Allocation Funds
- Monthly Income Plans
- Gilt Mutual Funds
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