Breaking down debt funds
A debt fund is a mutual fund scheme that invests in fixed income instruments.Updated: Jul 30, 2019 09:18 IST
The debt funds milieu is a bit more complex than equity funds and debt funds are impacted by a vast variety of macroeconomic and global factors, according to experts. A debt fund is a mutual fund scheme that invests in fixed income instruments, such as corporate debt securities, government and corporate bonds, and money market instruments that offer capital appreciation. Income funds or bond funds are also referred to as debt funds. According to the Securities Exchange Board of India (Sebi), there are 16 defined categories of debt funds. Mutual fund companies are allowed to float one scheme per category. The total expense ratio of debt funds ranges between 0.8% and 2%.
Debt funds mostly invest in government securities, PSU bonds, bank certificates of deposit, commercial paper and corporate debt paper. “Investments in debt funds are made in line with the investment mandate of the respective scheme. For instance, gilt fund can invest only in central or state sovereign credit while corporate bond funds largely invest in corporate debt of private or public sector undertakings. Commercial papers and company deposits are short term issuances of residual maturity of up to one year and find favour with liquid and ultra-short term funds,” said Lakshmi Iyer, chief investment officer of debt at Kotak Mahindra Asset Management Co Ltd. “The underlying nature of the fund determines what kind of debt paper is invested in those respective schemes.”
According to financial advisors, investing and monitoring factors that impact debt funds are more complicated than equity funds. “Unlike the case with equity-oriented funds, fixed income funds are more complex,” said Harsh Galaut, CEO, FinEdge, a Gurgaon-based financial advisory firm. However, there is a way to understand it and make it a part of your investment portfolio.
“A variety of macro factors such as wholesale price index, consumer price index, G-sec yield, current account balance, crude oil price movements are taken into consideration,” said Manish Banthia, senior fund manager, ICICI Prudential AMC. These factors, along with interest rate cycles, impact the net asset value (NAV) of your debt fund.
“Favourable macro conditions – such as falling inflation, lower fiscal deficit and reduced current account deficit – are good for bond prices as they tend to appreciate. This is due to the expectation of reduced interest rates going forward. This, in turn, impacts debt funds favourably and typically results in rise in NAV of such funds,” said Iyer.
“Usually when the central bank reduces interest rates, it means that growth has lowered and inflation has fallen. With this fall in interest rates, yields fall. Bond prices rise because of its inverse relationship with bond yields. An increase in bond prices means more capital gains for the debt fund investors,” said Devang Shah, deputy head of fixed income at Axis Mutual Fund. “The new bond issuance tends to align with prevailing market prices, and so coupons get adjusted accordingly,” said Iyer.
Certain global factors also impact the price movements.“The overall impact is routed through the dollar cycle in the global market. Therefore, it has an impact on the foreign portfolio investment activity and domestic interest rates, impacting both the rupee and the overall cost of funds. In turn, this affects the debt markets,” said Banthia.
Hence, there are many macro, domestic and global variables that affect direction of interest rate and on the basis of the direction, your debt fund portfolio is changed by the fund managers. “The good part is, in fixed income, there are strategies to suit various interest rate cycles. It would be prudent to seek help from an investment advisor to decide which category is best-suited to your investment needs,” said Iyer.
While macro-economic factors and interest rate fluctuations do impact bond prices, the decision to invest in them follow a slew of other factors. The duration of the underlying papers the debt funds are investing in is an important factor linked with these macro-economic factors.
“Generally we look for papers which have a lower maturity. If the papers have a very long maturity, they are more prone to interest rate fluctuations,” said Chitra Iyer, founder, Mumbai-based My Financial Advisor. Hence, the interest rate cycle matters a lot. “Currently the interest rate cycle is on the downward side and is prone to appreciation, with some potential of capital gains in longer tenure G-secs. But you never know what turn the Reserve Bank of India (RBI) takes next. Such interest rate fluctuations affect G-secs the most and not too much with corporate debt. So in case you are planning for a retirement goal where the duration is higher, you should increase your horizon to get capital appreciation and also look at AAA rates bonds,” said Suresh Sadagopan, founder, Navi Mumbai-based Ladder7 Financial Advisors.
However, the number of debt fund frauds coming in the market has made it difficult too. “Some planners still managed to escape the IL&FS crisis but they could not evade DHFL. Hence scrutinising the credit quality is extremely important,” said Iyer.
The duration of your investment horizon also matters. According to Sadagopan, the trick to this is to match the duration with your requirement. “Ideally you should have a three-year horizon to invest in debt funds to cover the costs of the effective taxation, which is generally to the tune of 10%. However, if you have a six-month horizon, you can look at liquid funds and if your horizon is around 18 months you can invest in arbitrage and short-term funds,” he added.
Other factors, according to Iyer, are expenses and how liquid they are. “Also, if they have invested in more number of papers, it means they are diversifying the risks.”
You should also keep in mind that debt fund returns are not “carved in a stone” like fixed deposits. These instruments are mark-to-market meaning their papers adjust to the market values at all times and the NAV will fluctuate, so you should have the stomach to adjust to this volatility,” said Sadagopan.