Debt Mutual Fund – A stable and steady investment choice

Bank fixed deposits and Government small savings schemes have been the traditional investment choice of average Indian households. As per Reserve Bank of India’s Quarterly Estimates of Household Financial Assets and Liabilities, Rs 4,753 billion was invested in bank FDs in FY 2018 (latest year for which data is available from RBI). On the other hand, despite its growing popularity, share of mutual funds in household fixed income assets is still relatively quite small. As per AMFI data (February 2020), retail and HNI net investment in debt mutual funds in the last one year (ending Feb 2020) was Rs 260 billion.

Debt Mutual Fund Schemes

Different investors have different investment needs depending on their financial situations, risk appetites and investment objectives. Debt mutual funds offer a spectrum of solutions for a wide range of investment needs, risk appetite and investment tenures. We will discuss about some key debt fund categories below.

Overnight Funds

These debt funds invest in fixed income instruments which mature overnight. These instruments have virtually no interest rate risk. These overnight instruments are backed by collateral which comprises of Government Securities, and so these funds also have no credit risk. These are the safest debt funds but their yield is usually also the lowest. Overnight funds are suitable for parking your funds for a few days.

Liquid Funds

Liquid funds invest in debt and money market instruments like commercial papers, certificates of deposits, treasury bill etc which mature within 91 days. Due to the very short maturities of their underlying instruments, liquid funds have very low interest rate risk. However, liquid funds may have exposure to credit risk depending on the credit quality of the underlying instruments. High credit quality liquid funds have very low risk and potentially offer higher returns than savings bank. According to SEBI directive, these funds charge graded exit loads for withdrawals within 7 days from the date of investment. Liquid funds are suitable for parking your funds for a few weeks or months.

Money Market Fund

As per SEBI’s mandate, Money Market Funds must invest in money market instruments like commercial papers (CPs), certificates of deposits (CDs), treasury bills (T-Bill) etc., having maturity of less than 1 year. These funds have moderately low price sensitivity to interest rate changes. However, these funds may be subject to credit risks depending on the credit quality of the underlying instruments of the funds. These funds are suitable for investors with moderately low risk appetites. Investors should have 1 – 2 year investment tenures for these funds.

Short duration Funds

Short duration funds invest in debt and money market instruments such that the Macaulay Duration of the portfolio is between 1 – 3 years. In simplified terms, Macaulay Duration is the interest rate sensitivity of a fixed income instrument. Due to their relatively short duration profiles, short duration funds have medium interest rate risk. These funds aim to hold the instruments in their portfolio till maturity and earn interest paid by them, aiming to give stable returns in different interest rate scenarios. Some funds can have exposure to credit risk depending on the credit quality profile of their underlying instrument. Short duration funds are suitable for 2 – 3 year investment tenures. Investors can avail of long-term capital gains tax benefits for 3 years + investment tenures.

Corporate Bond Fund

As per SEBI’s mandate, Corporate Bond Funds must invest at least 80% of their total assets in highest rated instruments. The highest rating given by agencies like CRISIL and ICRA for corporate bonds is AAA and for short term instruments i.e. instruments with maturity of 1 year or less e.g. commercial papers, certificates of deposits etc is A1. Corporate bond funds must invest 80% of their assets in such instruments. Even though AAA and A1 denote highest degree of safety, ratings can change over time depending on the financial performance of the issuer. Investors should monitor the credit quality profile of their funds on a regular basis.

Credit Risk Fund

As per SEBI’s directive, Credit Risk Funds invest at least 65% of their total assets in instruments which are rated below the highest rating. In other words, AA or lower (corporate) and A2 or lower for short term instruments i.e. instruments with maturity of 1 year or less e.g. commercial papers (CP), certificates of deposits (CDs) etc. Lower rated papers give higher yields but also have higher credit risks. Investors should understand the risks in these funds before investing.

Dynamic Bond Funds

Dynamic bond funds have the flexibility to invest across durations depending on their interest rate outlook. If the fund manager expects interest rates to fall, he / she will invest in longer duration instruments to benefit from price appreciation. Likewise, if the fund manager expects interest rates to rise, he / she will invest in shorter duration instruments to get higher yields and reduce interest rate risk. Dynamic bond funds usually have high sensitivity to interest rate changes. Investors should have appetite for short term volatility and a sufficiently long investment horizon. Investors should have at least 3 years or longer investment horizon for these funds. Over investment tenures of 3 years or longer, you can get long term capital gains tax benefits. Investors can use SIP to reduce volatility which may also improve returns of the fund.

Gilt Funds

These funds invest at least 80% of their assets under management in Government Securities. Hence these funds have very low credit risk. However, these funds have high sensitivity to interest rate changes. They can give high returns when yields are falling but can be quite volatile in the short term if yields spike due to any reason. Investors should have high appetite for volatility and at least 3 years or longer investment tenures for their Gilt fund investments.

Long Duration Income Fund

As per SEBI’s mandate, Long Duration Funds must invest in debt and money market instruments such that the Macaulay Duration of the fund portfolio is greater than 7 years. The Macaulay duration is the weighted average term to maturity of the cash flows from a bond. Macaulay duration is closely related to Modified Duration which is the price sensitivity of a fixed income instrument to interest rate changes. Long duration income funds are highly sensitive to interest rate changes. However, long duration funds usually have relatively low credit risk because these funds invest predominantly in G-Secs. Since these funds have fairly high interest rate risk, investors should have moderate risk appetites and sufficiently long investment tenures (at least 3 years).

Why invest in Debt Mutual Funds?

Debt funds can give higher returns

Debt funds are fixed income mutual fund schemes which invest in debt and money market instruments like CPs, CDs, Corporate Bond, T-Bills, G-Secs etc. These instruments pay interest (coupon) at pre defined intervals and the face value (principal) upon maturity. The yields of many of these instruments are usually higher than bank FD interest rates of similar maturities. Yields of AAA rated corporate bonds can be 150 – 200 bps higher than FD interest rates. In addition to higher yields, since these instruments are traded in the market, you can benefit from price appreciation.The chart below shows the trailing returns of different debt fund categories over different tenures.

Debt funds are tax efficient

Bank FD interest is taxed as per the income tax rate of the investor. Capital gains in debt funds held for over three years are taxed at 20% after allowing for indexation benefits. Indexation benefits can reduce tax obligations substantially for investors in higher tax brackets. Incidence of taxation in fixed income funds arise only if you redeem (sell) your mutual fund units or if you receive dividends. Capital gains on your redemption proceeds and dividends are taxed differently.

Capital Gains Tax

There are two kinds of capital gains in fixed income funds:-

Short term capital gains: If units of fixed income funds are sold within 36 months from the date of purchase then capital gains arising out sale of units will be treated as short term capital gains for tax purposes. Short term capital gains are added to your income and taxed according to your income tax slab rate.

Long term capital gains: If units of fixed income funds are sold after 36 months from the date of purchase then capital gains arising out of sale of units will be treated as long term capital gains for tax purposes. Long term capital gains are taxed at 20% after allowing for indexation benefits.

SIP in Debt Mutual Funds

How does SIP in Debt mutual funds work?

By investing a fixed amount every month (or any other interval) from your regular savings, you can invest over a long period of time and benefit from the power of compounding. Power of compounding does not only work for equity, it also works for fixed income over long investment tenures.
By investing a fixed amount at regular intervals (monthly or any other), you will be investing at various price points and average out your purchase cost. This is known as Rupee Cost Averaging. Since fixed income funds are market linked schemes their prices are also subject to volatility (albeit lesser than equity funds). Through SIP you can take advantage of volatility even in fixed income funds especially in longer duration fund which are more sensitive to interest rates.

Fixed income can outperform even in the long term

Extreme market conditions often challenge popularly held views. One view is that equity always outperforms in the long term. This is largely correct because historical data shows that, equity has been best performing asset class in the long term. However, conventional thinking about what constitutes long term is now being challenged. The chart below shows the annualized average returns of some equity and fixed income categories over the last 3, 5 and 10 years. You can see that in certain market conditions, fixed income funds can outperform equity even over fairly long tenures.

Source: Advisorkhoj Research, 31st March 2020
Past performance may or may sustain in future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.

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