Thursday, May 28, 2020

Business

How to choose debt funds

April 25, 2020 03:22 PM

Debt funds are ideal for those investors that are looking for a regular income stream but unwilling for risks. Being less volatile, debt funds assure returns on investment, but not as much as mid and small-cap mutual equity funds. So debt mutual funds are a preferred alternative to fixed deposits given the assured returns, exposure to lower market variables hence lower risk, tax efficiency, and safety of capital.

Classified as a mutual fund scheme, debt mutual funds tend to the following fixed income investments/instruments:

  • Government bonds – The government issues these securities/bonds. When purchasing them, it is akin to lending money to the government (issuer). The issuer is liable to pay interest at pre-defined intervals over the bond’s tenure. After the tenure, the issuer repays the bond’s principal amount. These are debt funds for long term investment horizons.
  • Corporate bonds – Companies issue them. Companies issue bonds with varying degrees of debt. Companies can be start-up organizations, small enterprises to large organizations. The risk profile of corporate bonds is higher; therefore, returns are also higher than government bonds.
  • Corporate debt securities – This is a debt instrument. It is similar in definition to corporate bonds.
  • Treasury bills – Used by the government to generate capital. Works similar in principle to government bonds.
  • Commercial paper – It is issued by corporations to raise short-term capital. Usually used by companies to fund procurement of inventories, regularize payroll, etc. Commercial papers are a type of corporate bond. These are short term debt mutual funds.

Money market instruments – Are capital (low cost of acquisition) provided to small businesses, large businesses, medium-sized businesses, banks, and government. The tenure of this debt fund is within a year.

How do debt funds work?

  • Debt mutual fund managers (individuals, agencies, companies) invest in bonds/securities/billsbased on their creditworthiness. Security (issued by a government/company) is classified as high-risk, medium-risk, or low-risk depending on its creditworthiness.
  • High-risk debt funds for investment may not be low-rated. Low-risk securities may not be high-rated. Therefore, a balance can be achieved. However, when it comes to debt funds, given that they are not equity mutual funds, it is standard to go for highly-rated funds – regardless of their being high-risk or low-risk.
  • The maturity of the security also depends on the strategy of the investment house that manages the debt fund. As per the prevailing economic conditions, the investment manager decides to take long-term debt funds or short-term debt funds depending on whether the interest rate regime is on the decline or incline. This strategy provides some debt funds meaning.
  • Who can invest in debt funds?

The conservative set of investors can. Debt funds India investment houses usually invest in all baskets of securities. This ensures predictable, decent returns. Debt funds are suitable for short-term or medium-term investment requirements. Short term and long term investment horizons have the tenures three months to a year and three years to 5 years, respectively.

  • Debt fund type

No two investors are the same. Catering to their diverse interests and requirements, there are multiple types of debt funds with varying debt mutual funds returns. Each debt type is primarily differentiated by their tenure, and the entity is issuing it.

  • Bond funds (dynamic)–The fund manager fluctuates fund allocation in instruments based on the interest regime. The portfolio composition’s dynamic nature ensures that money is moving from high-risk to low-risk areas constantly. The average maturity period of dynamic bond funds could vary.
  • Income funds – These are long-term debt mutual funds.
  • Short-term funds – Debt mutual fund schemes with shorter maturities. Unaffected by interest rates. May yield high returns or nominal returns.
  • Liquid funs – Maturity of these debt mutual funds is within 91 days. They are a better option than fixed deposits if short-term liquidity is the prime concern. Mutual fund companies provide special debit cards for investors to withdraw their liquid funds.
  • Gilt funds– are risk-averse investments in debt funds. It is made exclusively in government securities.
  • Credit opportunities debt funds – are riskier investment strategies to generate higher returns. Investment managers try to stay optimistic on lower-rated securities that could have the potential to create value.
  • Fixed maturity plans– Debt securities are locked-in for a pre-defined investment horizon period. It may look like a fixed deposit scheme, but the difference being that it may yield higher returns than FDs

Points to consider before choosing debt mutual funds

  • Risk – Debt mutual funds could seem like an extension of a bank’s fixed deposit scheme. Debt funds are usually riskier than bank FDs. To generate higher returns, the investment manager could invest funds in low-rated or unknown securities as a throw-of-the-dice strategy. Interest rates are also not guaranteed as bond prices could decline due to interest rate increase.
  • Return –Debt funds could seem like havens of fixed-income returns. But they don’t always guarantee returns. If in the economy, the prevailing interest regime is on the higher side, the Net Asset Value (NAV) of the security increases and vice-versa. Hence debt funds can be taken when the interest rates are on a decline because, after a point of time, the interest rate would pick up again, thus providing more returns on investment.
  • Cost – Debt fund investment managers or investment houses levy an expense ratio. The upper limit is capped at 2.25 percent of the overall fund. Debt funds generate lower returns than equity mutual funds. So a consensus can be made on the corpus of the amount to invest in debt funds so as not to negate the profits realized because of expense ratios.
  • Investment horizon – Longer investment horizons yield higher returns. Although the temptation of going short-term is always there, not worrying too much about liquidity or instant gratification is the key. So debt funds with tenures ranging from 3 to 5 years can be taken to achieve guaranteed returns.
  • Financial milestones – Debt mutual funds can function as alternative income streams. Newbie investors can invest a portion of their income in short-term high-liquidity debt instruments to gain a perspective on how their money is faring in the markets.
  • Tax on profits – Profit realized (capital gains) on debt funds are subject to tax. So consider this aspect too before calculating proposed net gains on debt fund investments.

Conclusion

Debt funds are relatively safer than equity mutual funds. They can be a part of an investment portfolio along with equity mutual funds.

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