How does Debt Funds work and where do they invest?
Debt Fund’s source of returns are interest income and capital appreciation. Capital appreciation is unique to debt funds which is generated through trading of securities.
Investors need to be aware that in Debt funds price is inversely proportional to Interest Rate and Yield. i.e. when interest rates go down, the value or price of the security goes up. Yield in simple terms is the interest paid on the current price of the bond. For a 10% interest rate (coupon) bond with face value of 1000, if the interest rates in the market decreases and price increases to 1100/-, then the yield would be Rs. 100 upon 1100, the current price resulting in a value of 9.1%.
In a decreasing interest rate scenario like the current one where the RBI rates have fallen, bond funds and gilt funds (government bonds) tend to do well. When the reverse happens, then the fund value goes down which means right entry and exits point are required for medium to long term debt funds that rely on capital appreciation
Debt Funds invest in the following instruments depending of their category:
Treasury bills (T-Bills) – Short term instruments issued by RBI on behalf of Government to meet short term requirements of funds
CBLO – This instrument is used for lending and borrowing from overnight to 14 days against collateral of debt securities, similar to call money market
Certificate of deposits (CDs) – this is similar to fixed deposits where the Bank issues certificates to Mutual Funds which they can hold until maturity or trade
Commercial Paper (CPs) – This is similar to company deposits where companies issue these instruments for their short term funding requirements
G-Secs – These are government securities issued by RBI for periods of 1 to 30 years. The 10 year G-Sec is used as a benchmark and the yield on 6.97 %( coupon or interest rate) G-Secs maturing in 2026 is quoting at 6.23
Corporate Bonds and Debentures – Debt instruments issued by corporates for various time periods (Maturity dates). Rating agencies (CRISIL, CARE, ICRA etc.) assess these instruments and provide a rating.
Liquidity and Flexibility
The short term debt instruments like Liquid Funds and Ultra Short Term funds have high liquidity as the securities that they invest have short maturity. Both these products do not have exit load (A few Ultra Short Term do have small exit load). These are excellent alternatives to Savings Bank and short term FDs and in the current scenario, has the potential to deliver returns higher than even long term Bank FDs. The flexibility that these funds offer is such that the redemption proceeds are credited to the investor’s bank A/c’s the next business day. Unlike FDs where the interests paid increases by tenure and when the deposits are prematurely surrendered have a penalty clause, the returns provided by Liquid and Ultra Short funds are almost linear which means if the fund yields say 8% for a year, even if an investor stays in the fund for just one week, they would get similar returns.
Taxation of Debt Funds
Debt funds have a favourable tax treatment over traditional Postal, Bank and Company fixed deposits.
Debt funds invested in growth plan for less than 3 years (Short Term Capital Gains is applicable) are taxed at the slab rate of the investor and the treatment is no different from traditional deposits. However, if the investor chooses dividend option, the fund house pays dividend distribution tax (DDT) at the rate of 28.84% on the corpus assigned for the dividend and the net balance post DDT tax is provided as dividends to the investors, which are tax free. This option works better for people above the 10L tax slab where the tax rate is about 31%. However, the dividend option is not ideal for investors in 10% and 20% tax slabs.
When a debt fund investor chooses the growth option and remains invested for greater than 3 years (Long Term Capital Gains), Indexation benefit (Cost Inflation Index) is applicable to them and only the difference between the indexed cost of investment and the current value is taxed @20%, irrespective of the tax slab of the investor. This is an excellent incentive for investors to consider debt funds rather than traditional products. The following illustration gives a picture of how it works. The CII (Cost Inflation Index) is published every year by Finance Ministry and CBIT (Central Board of Income Tax) and the value for FY16-17 is 1125
Credit Risk
Credit risk refers to the risk of the debt issuer defaulting on interest and/or principal payments. Other than Government securities all other debt products are exposed to Credit Risk. The Rating agencies (CRISIL, CARE, ICRA etc.) assess the Credit profile of these instruments and provide a rating. Typically, the lower rated securities offer higher interest rates and higher rated securities offer comparatively lower interest.
Debt Funds Ready Reckoner
The following table can be considered as a ready reckoner for the various categories of debt Fund, recommended tenure, risk rating (as mandated by SEBI) & average returns for different time frames. Risk Rating is a visual Risk profile of the fund with 5 levels including Low, Moderately Low, Moderate, Moderately High, and High.
The returns for 3 months period is absolute and for 1 year and 3 years, its annualized. Investors are requested to start investing in Debt MFs by taking exposure to Liquid and Ultra Short Term funds which have the least risk profile
Every investment that we make comes with a risk & return profile and so are Debt MFs. The risks need to be understood and allocation to various asset classes needs to be done so as to maximize returns with minimum risk to ones Portfolio
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