What are Debt Funds?

Debt funds are the mutual funds which combine the feature of capital appreciation with safety. They invest in various types of debt securities issued by different issuers having different characteristics. These debt securities such as Treasury bills, G-secs, Certificate of Deposits (CDs), Commercial Papers (CPs), Bonds and money market securities are market tradable and provide the scope of capital gain apart from interest. Especially in India, where the debt markets are underdeveloped, debt funds are sometimes the only way to invest in the debt market. These funds also score over direct investment in a bond because they offer diversification, liquidity, tax benefit, experts’ touch and convenience of investing. Multiplicity of dividend options (daily, weekly, fortnightly, monthly) makes them more lucrative.

Although debt products command a very large percentage in an average Indian investor’s portfolio, debt mutual funds have not enjoyed the kind of popularity they could have. However with the evolvement of mutual fund industry, domestic funds now offer a wide range of pure debt funds and given the tax treatment
and high inflation, one can’t give them a miss.

Types of Debt Fund & their role in a portfolio

As debt securities involve coupon payments, maturity period is the deciding factor in their classification. Similarly a debt fund should be selected when the average maturity of the fund and the investment tenure are in synchronization.

Liquid Funds

Liquid funds are ideal to park money for a few days or weeks. They are able to catch the rising short term interest rates because they invest in very short term debt instruments. They are also best used with the facilities provided by mutual funds such as Systematic Transfer Plan, Systematic Withdrawal Plan and Entry at Trigger. To invest the contingency fund in liquid funds is also a very good option. Although these funds aren’t as liquid as saving bank account, they offer much better returns.

Floating Rate Funds

Floating Rate Funds score over other debt funds during upward interest rate movements. When the benchmark rate (such as MIBOR) increases, coupon rates of floating rate debt securities also adjust in line with the benchmark. So they offer fairly close to market returns. An investor who is more concerned about capital protection and wants stable returns in line with interest rate movement should look forward to floating rate funds.

Short Term Funds

These funds are good options if investment horizon is of six months to two year. Planners must watch out economic events before taking exposure in these funds. For example if short term interest rates are expected to fall in expectation of liquidity easing, short term fund would be an attractive option. Similarly, if the interest rate keeps rising, it will be difficult to capture the higher interest rate unless an investor liquidates his debt investment to invest again at the higher rate. But if he invests in short term fund, he can hope to capture the higher interest rate that may be on offer.

Long Term Funds

These Funds, either income or gilt, can be an important component of the active part of a portfolio in a falling interest rate regime. As interest rates fall, bond prices move upward and these funds provide significant capital appreciation. Planners have to take care that funds should be invested when the benchmark 10-year bond yield is at its higher end and redeemed when it comes at the lower end. Timeframe should be of two years or more so that even interest rate moves up in the short term, the investor can wait to ride the rally arising out of falling rates in the long term. G-secs are worst hit in times of debt market volatility because they are most frequently traded and have longer maturities and therefore gilt funds shouldn’t be added in a portfolio when interest rates are rising.

Fixed Maturity Plans

The only close ended debt scheme is FMP. FMPs were a big hit over the past years because of their tax efficiency and better returns than bank deposits. The tenure of FMP can range from 90 days to up to 3 years. It is imperative to match the time horizon of investment with the maturity of the FMP as the option to exit before maturity is available on stock exchanges only and trading is almost negligible.

Taxation

The financial planning process involves the after tax real rate of return and here debt funds get an advantage of being tax efficient in comparison of traditional debt products with the benefit of indexation. The Finance Bill 2011 has brought some changes in taxation of debt funds. With effect from April 1, 2011 the surcharge of 7.5% is reduced to 5.0%.

Table 1: Dividend Distribution Tax ( Effective from June 1st, 2011)
	Individual / HUF	Corporate
Liquid Funds	27.038%	32.445%  (27.68% till 30.05.11)
Other Debt Funds	13.519%	32.445%  (22.15% till 30.05.11)

(including 5.0% surcharge & 3.0% cess)

It is better to opt for dividend option in liquid funds if the investor falls into highest tax bracket as DDT on liquid funds would be lower than STCG otherwise growth option should be considered.

Table 2: Taxes on Capital gain
		Individual / HUF	Corporate
Long Term Capital Gain	Without Indexation	10.30%	10.815%
	With Indexation	20.60%	21.63%
Short Term Capital Gain		Depends on Tax Slab	32.445%

 

Under the proposed Direct Tax Code (effective fromApril 1, 2012), debt funds have to follow the new rule of indexation. Currently indexation takes into account the inflation during the holding period. For example, if investment is made in March 2009 till April 2011, the indexation benefits will be for 3 financial years.

Under the DTC, the asset will have to be held for more than one financial year from the end of the year of investment to avail of indexation benefit. So investment made in the month of March will get indexation benefit of only one year if it is hold till the end of next financial year.

Limitations

The notable point is that debt funds do carry some risk. But as long as an informed investment is made, risks can be minimized.

Credit risk is the risk that an issuer may be unable to make timely payment of interest or principal. But as debt funds invest mainly in top-rated instruments and that also of many financial institutions, the risk of default is very low.

Interest rate risk arises from the inverse relationship between interest rate and the bond price. An increase in interest rate and its resultant declining bond prices make NAV moves down. The longer is the maturity of a particular bond, the more is the impact. Hence, debt funds invest in bonds of low tenors when rates are rising to reduce the adverse impact of interest rate risk.

Fund managers’ trading skills also play the important role in fund’s performance. A high turnover ratio and frequent changes in maturity period may adversely affect the fund’s performance. In unpredictable times, the fund manager is expected to act carefully.

Table 3: Historical Performance of debt funds in falling rate regime

Repo Rate (%)  in FY 2008-09
July 29, 2008	9
October 20, 2008	8
November 3, 2008	7.5
December 8, 2008	6.5
January 2, 2009	5.5
March 4, 2009	5

 

Period: April 1, 2008 to March 31, 2009		Return (%) of
Fund Type	Average Return (%)	Best Fund	Worst Fund
Gilt Funds: Long Term	11.46	31.11	-7.61
Income Funds	9.42	27.94	-5.04
Short Term Funds	8.85	16.46	0.87
Liquid funds	8.2	9.8	-3.08

The wide gap between the best return and the worst return reflects the importance of fund manger’s investment style. Planners need to examine the details of fund such as portfolio composition, expense ratio, exit load etc and check the risk adjusted returns using various tools such as Jensen’s alpha.

Planner’s Perspective

Planners have an idea of macro environment and various types of economic events such as changes in monetary policy, liquidity conditions, inflation, government spending & borrowing, industrial stats which can affect debt market and interest rate movements. And therefore, depending upon clients’ investment horizon, risk appetite, tax status and liquidity needs, planners can play a key role in determining the debt fund investment strategy. As interest rates have big influence on the performance of the portfolio and economic factors must be taken in account, planners should also consider rebalancing of clients’ portfolio.