What is a Debt Fund
Mutual funds can broadly be classified as either an Equity Fund or a Debt Fund. All other mutual fund categories are offsprings of these two
categories. A detailed article on Mutual Funds can be found at What is a Mutual Fund. A debt fund primarily invests into Bonds and Fixed deposits. The returns of a debt funds is hence dependent upon how bonds perform. You may hence want to first read our article ‘Making Money Out of Bonds‘ to get an understanding of what bonds are.
Why To Invest in Debt Funds
Debt market in India is not very developed. The most widely available debt products are PPF, PF, Fixed Deposits and Post office deposit schemes. One of the most important debt security ‘Corporate bond’ is not really available to retail investors in India and is generally restricted to large institutional investors with minimum investment ticket size in many cases over a crore. Hence in most cases, if the investors are looking out to invest into debt category, other than the PFs and PPFs / FDs, they have to look out for Debt mutual funds which in turn invest into Corporate Bonds.
While the above paragraph stresses on the lack of availability of debt instruments for retail investors as one of the reasons for advocating investments via debt funds, other supporting reasons may be :
1. Diversification : Debt / bonds are essentially loans provided to Companies. If a Company defaults or goes bankrupt, then the entire investment in the bonds of that Company would turn into a big loss. The risk of a borrower not repaying their dues is called ‘Credit Risk’. Most bonds are denominated from anywhere between Rs. 10,000 to Rs. 100,000 per bond. A retail investor generally does not have significant saving and their entire fund may end up being invested in a single bond. Hence they may not have the financial capability to diversifying the Credit Risk of the bond issuers by investing into bonds issued by different Companies. It is here where Debt Mutual funds come handy whereby an investor can buy units of a debt fund from their savings. For example, if an investor has just Rs. 10,000 to invest into debt, they can buy units of a debt fund from this amount. The Debt fund would combine the savings of all such investors and invest into diversified pool of bonds / fixed deposits and hence spread the credit risk of default of bond issuers to multiple companies.
2. Credit Research : When investing into debts / bonds, the last thing which an investor would want is the company in which they have invested their hard earned money turns into a defaulter and is unable to return their invested amount. To avoid such costly mistakes, an investor would need to perform considerable research and trod through the scrolls of financial papers of the respective company and the economic conditions which may affect the future financial viability of the company and its cashflows. In many cases this may not be possible for an investor for sheer lack of technical skill sets required to perform financial analysis of a Company. By investing into a bond via Debt funds, an investor outsources the credit research aspect in bonds to the credit experts employed by the respective Mutual Fund house who in turn thoroughly research the credibility of the bond issuers before investing into their bonds.
3. Hedging of Credit Risks : An investor can either diversify their credit risk by investing in a basket of bonds from different bond issuing companies or take a hedge against the credit risk of the borrower. ‘Hedging’ means to pass on the risk to another person who is happy to bear the losses in return of a fees. Credit risk is generally hedged by taking a ‘Credit Default Swap’ or CDS. In this case a debt fund reduces the risk of default of a borrower by taking an insurance policy in the form of a CDS from another financial institution. If the borrower defaults in future, the entire amount invested with the borrower is then recovered from the financial institution who sold the ‘CDS’ to the mutual fund. Again, taking a hedge on a credit risk is a complicated financial transaction which is generally outside the reach of the retail investors.
4. Liquidity of Investments : Lets understand it with an example. If you invest into a PPF, it gets locked for 15 years. If you invest in a FD, you can’t liquidate without a penal rate. Same is with any other bond investments if you have been lucky to invest in. SBI recently came with a 15 year bond issue. Many of the retail investors were successful in getting a pie of that investment. This bond was then listed on stock exchange to provide an exit route to investors who wanted to liquidate their holdings in case of emergency / liquidity reasons. However, due to poor number of buyers and sellers for this bond on the stock markets, the value at which you can liquidate your bond holdings is not reflective of its actual worth. Either it goes too cheap or too expensive ! If you invest into bonds via Mutual Funds, then you its daily price in the form of NAV which reflects accurate pricing of the underlying bond holdings. You can liquidate at any time you want, subject to the prevailing exit load charges, hence providing the much required liquidity to your investments.
Options available in Debt Mutual Funds
Depending upon the types of investments held by a debt fund, they are categorised into the following categories :
Long Term Debt Funds
Long Term Debt funds invest in debt securities with a long dated maturity, generally over 5-10 years and can be in some cases be over 30 years. A price of a debt fund of this type is generally volatile and is sensitive to the day to day economic changes. Such funds should be chosen if you have a long term investment objective (generally over 3-5 years). These mutual funds hence also enforce an exit load to discourage investors to sell their holdings before 1 year duration.
Short Term Funds
These funds inveset in debt securities having maturities any where between 1-3 years. Considering that the securities held by them are of a smaller maturity duration than of the Long Term Debt funds, they are less volatile. This category of fund is suitable for investors having an investment duration over 1 year. Similar to Long Term Debt funds, Short Term funds also enforce an exit load.
These funds invest into securities of very short maturity, generally upto 90 days. They also invest into over night money markets – where banks & large corporates borrow hugh amount of funds (ticket size over 10-100 crore) for 1 day to 1 week to fill the liquidity gap in their funding. Considering that the maturity profile of the underlying securities is very short, these funds are least volatile and most secure. They are an ideal choice if you want to park your funds temporarily and want to take any risk associated with the funds. Liquid funds do not charge exit load due to the obvious short term investment horizon in such funds. To know more about how to use Liquid Funds, please read our article ‘How to make Money from Idle funds in your Bank Account’
Monthly Income Plan (MIPs)
MIPs are a special category of debt funds which invest between 75-100% of the funds into debt securities. Any remaining fund amount is invested into Equity markets. The rationale behind investing in these funds is to have the stability of a debt security in the portfolio and at the same time provide an opportunity for the investments to grow at rate higher than the Debt securities by investing a small portion of the corpus into Equity shares. The reason why these plans are named as ‘Monthly Income’ is because the fund managers aim to provide a monthly dividend to the unit holders so that it can function as an income for the investors. Owing to an equity component in this category of fund, it is advisable to invest into MIPs with an investment horizon of around 3-5 years.
Debt funds are not the most tax efficient investments around in the market. But hey, the stability of a debt fund comes with this price. Tax rebates are currently available only for investments into Equity oriented investments. Debt funds get taxed from anywhere 0 % to 30%, depending upon your tax slab. A very detailed article on tax implication of all mutual fund categories can be referred to at ‘Tax Implication of Mutual Funds on Residents and NRIs‘.