Debt funds a detailed analysis and different options.

If you want to avoid market fluctuations of equity stocks and are risk-averse consider investing in Debt oriented Mutual Fund Schemes.

What is DEBT FUND?

A debt fund is a mutual fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also referred to as Income Funds or Bond Funds.

Debt Funds for STP/SWP

Debt funds also allow you to take advantage of investing in equity market along with growth on your principal amount through Systematic Transfer Plan (STP). With an STP, you can transfer amounts in parts/tranches from one mutual fund scheme to another, within the same fund house at regular intervals. Such a transfer averages the cost of purchase, mitigating some market-related risks. Typically, an investor first parks his funds in a liquid or a floating-rate debt fund and then transfers them via STP to the scheme (usually equity or balanced) of his choice at regular intervals. A systematic withdrawal plan (SWP) is a payment option in a mutual fund that lets you redeem units worth a pre-specified amount at specific intervals (monthly, quarterly, half-yearly or annually). This is suitable for investors who desire periodic income.

Using Debt Funds for Specific Goals.

Choosing funds for children’s education.

When it comes to taking the mutual fund route for your children’s future, the basic rules of the game are essentially the same as that for any long-term goal. But here, merely investing will not work. You need to be cautious about the risk management of your corpus, especially when your child is close to going for his higher studies. Along with investing, making the money available at a time when your child needs it is equally important. So, here debt funds play a vital role. With time on your side, investing in equity has many advantages. But you need to keep a close eye on the market once you are less interval than three years away from your goal. One needs to de-risk the portfolio when you are nearing your targets to ensure that the gains you have earned are not wiped out. In other words, as you near your target, start shifting from equity to debt so as to secure your gains.

When moving away from high-risk options, you could choose to move into liquid and short-term debt funds or slightly riskier funds in the debt space, such as bond and gilt funds, depending on the interest rate scenario prevailing at that time. For instance, if the interest rates are falling, short- to long-term bond and gilt funds would bode well. But if interest rates remain flat or move upwards, stick to liquid funds; they are safer than the rest of the debt schemes, if not the safest of all financial instruments, and they would still earn you more than your savings bank account.

The ideal way to build an adequate corpus for your child’s future is to go step by step – through Systematic Investment Plan or SIP. The sooner you start, the better. Of course, you also need to stop along the way occasionally to make sure things are going as planned. The closer you get to your investment goal, the more careful you need to be that you are not taking a wrong turn.

Role of debt fund in a retirement portfolio.

As you age, lighten your equity funds holdings marginally; the aggressive investor should cut equity in his portfolio from 80 per cent to 70 per cent, and the conservative investor from 60 per cent to 40 per cent. With about 15 years away from retirement, you should start playing steady and balance your exposure to debt and equity. For instance, the conservative investor may choose a 10-20 per cent higher debt allocation. On the debt side, you may look at floating-rate funds and fixed maturity plans. Balanced funds are another option for the semi-aggressive investor to strike a debt-equity mix.

Strategy - Follow the life stage approach to investing while saving through mutual funds for retirement needs. As you age, keep balancing the allocation between equity and debt.

With around 10 years away from your retirement, your priority should be to ensure the safety of your accumulated wealth. Plan out the de-risking strategy and wait for an opportune time to migrate your money from volatile equity to safer debt. By the time you are 1-2 years away from retirement, a large portion should have been moved away from equity into debt funds.

Acquiring a house

Investing in mutual funds not just helps in the creation of wealth but also helps in creating assets. They play an important role in helping one build the biggest asset of life—a home of your own.

Paying the equated monthly installments (EMIs) have come reasonably within the reach for most families, especially when both partners work. However, accumulating a big lump sum to pay the down payment on the house remains the biggest obstacle. This is where mutual fund schemes come in handy. All those who live on rent constantly wonder why they should be throwing their hard-earned money out as expenses, when they could use it to buy a house and create an asset. That is more so now, when property prices have, perhaps, settled down and when home loans are easily available as housing finance companies are offering easy loans to customers. If you are contemplating buying a house in 2-3 years, mutual fund schemes can help you accumulate the money, especially the down payment for the loan.

Generating funds from friends, relatives or pawning gold might not be the best way to arrange the money. Plan early to avoid depending on such sources as far as possible. If you feel that your personal circumstances are right for buying a home, start by creating a savings plan for your down payment. Get an idea of the purchase price and the EMI payments that you can afford. Estimate what you’ll need for margin money, which is usually 20 percent of the home price. Thereafter, calculate how much you must save every month.

Where to invest if the time.

Horizon is less than a year or just a year away, it is better to stash funds in a money-market or liquid fund. The volatility in these funds is the least as exposure to equities is non-existent. The idea is to preserve the capital and not take undue risks with the savings. Choose at least two or three debt funds for diversification and start saving through the systematic investment plan (SIP) process. Ideally, keep the portfolio tilted towards debt even if you are taking a bit of risk.

Strategise your moves.

Remember, even debt funds suffer from interest rate risk. So, ensure that you shift to less volatile debt funds, such as short-term debt funds, at least two years before reaching your goal. With just one year away from your goal, shift your savings completely into a liquid fund. Your small savings every month might not cramp your household budget, but they will still create a lump sum big enough to meet your down payment needs for a home.

There is a wide choice, to invest as per the investor’s risk-return profile and life stage. Note that the choice of schemes is illustrative. For instance, a young investor at the start of her career as higher risk appetite and time horizon and, thus, she can look at investing in long-term debt categories such as monthly income plans, gilt funds, long-term income funds and credit opportunity funds. As the investor’s age advances, the risk-taking capacity may diminish. Hence, investment in shorter maturity schemes such as fixed maturity plans, liquid funds and ultra-short-term debt funds may be considered. The shorter lock-in period ensures that funds can be accessed to meet both expected and unscheduled financial obligations.

A small portion of the equity in the portfolio could enable investors to generate inflation-adjusted returns in the medium to long term. A good alternative to a savings bank account; potential to offer higher post-tax returns.

Follow an investment structure that seeks to protect the initial investment from capital erosion. This type of scheme offered is “oriented towards protection of capital” and “not with guaranteed returns”. The orientation towards the protection of the capital originates from the portfolio structure of the scheme and not from any bank guarantee, insurance cover etc. CPFs have a small equity component which gives risk-averse investors an opportunity to participate in the equity markets without worrying about erosion of the principal which is protected. CPFs are also rated by credit rating agencies.

There are various types of schemes in the debt fund category, which are classified on the basis of the type of instruments they invest in and the tenure of the instruments in the portfolio, as explained below:

Liquid Funds

As the name suggests, invest predominantly in highly liquid money market instruments and debt securities of very short tenure and hence provide high liquidity. They invest in very short-term instruments such as Treasury Bills (T-bills), Commercial Paper (CP), Certificates Of Deposit (CD) and Collateralized Lending & Borrowing Obligations (CBLO) that have residual maturities of up to 91 days to generate optimal returns while maintaining safety and high liquidity.

Redemption requests in these Liquid funds are processed within one working (T+1) day. The aim of the fund manager of a Liquid Fund is to invest only into liquid investments with a good credit rating with a very low possibility of a default. The returns typically take the back seat as protection of capital remains of utmost importance. Control over expenses in the form of the low expense ratio, the good overall credit quality of the portfolio and a disciplined approach to investing are some of the key ingredients of a good liquid fund.

Most retail customers prefer to keep their surplus cash in Savings Bank deposits as they consider the same to be safest and they could withdraw the money at any time. Liquid Funds and Money Market Mutual Funds provide a more attractive option. Surplus cash invested in money market mutual funds earns higher post-tax returns with a reasonable degree of safety of the principal invested and liquidity.

Liquid funds are preferred by investors to park their money for short periods of time typically 1 day to 3 months. We suggest liquid funds as an ideal parking ground when you have a sudden influx of cash, which could be a huge bonus, sale of real estate and so on and you are undecided about where to deploy that money. Investors looking out for opportunities in equities and long-term fixed income instruments can also park their money in the liquid funds in the meantime.

Many equities investors use liquid funds to stagger their investments into equity mutual funds using the Systematic Transfer Plan (STP), as they believe this method could yield higher returns.

Liquid Funds typically do not charge any exit loads. Investors are offered growth and dividend options. Within the dividend option, investors can choose daily, weekly or monthly dividends depending on their investment horizon and investment amount.

Overnight Funds

Overnight funds invest in CBLOs, overnight reverse repos, and other debt or money market securities that mature in one day. This is in keeping with SEBI norms, which requires them to invest only in assets with overnight maturity. The entire asset holding of an overnight fund can be classified as "Cash and Cash Equivalents". The portfolio of an overnight fund is replaced every day with new overnight securities. Overnight schemes are not permitted to invest in deposits or specified risky debt instruments; this rule aims to reduce the risk of default in their bond portfolio.

Overnight funds earn only through interest payments on their debt holdings. There is no scope for earning capital gains as the securities held by the fund mature in one day. In fact, returns of overnight funds reflect overnight lending and borrowing rates. When interest rates are falling, and short-term liquidity is abundant, overnight rates in the money market decline. When interest rates are rising, and market liquidity is tight, overnight rates increase. Thus, returns of overnight funds are closely linked to rates and conditions in the overnight market for funds.

Short-Term funds

Short-term debt funds primarily invest in debt instruments with shorter maturity or duration. These primarily consist of debt and money market instruments and government securities. The investment horizon of these funds is longer than those of liquid funds, but shorter than those of medium-term income funds.

Floating Rate funds (FRF)

While income funds invest in fixed income debt instruments such as bonds, debentures and government securities, FRFs are a variant of income funds with the primary aim of minimizing the volatility of investment returns that is usually associated with an income fund. FRFs invests primarily in instruments that offer floating interest rates. Floating rate securities are generally linked to the Mumbai Inter-Bank Offer Rate (MIBOR), i.e., the benchmark rate for debt instruments. The interest rate is reset periodically based on the interest rate movement. The objective of FRFs is to offer steady returns to investors in line with the prevailing market interest rates.

Gilt Funds

The word ‘Gilt’ implies Government securities. A gilt fund invests in government securities of various tenures issued by central and state governments. These funds generally do not have the risk of default, since the issuer of the instruments is the government. Gilt funds invest in Gilts which have both short-term and/or long-term maturities. Gilt funds have a high degree of interest rate risk, depending on their maturity profile. The longer the maturity profiles of the instruments, the higher the interest rate risk. (Interest rate risk implies that there is an effect on the market price of debt instruments when interest rates increase and decrease. Market prices of debt instruments rise when interest rates fall and vice versa.)

Interval funds

Interval funds are taxed like any other mutual fund, depending on whether the underlying portfolio is predominantly invested in equities or debt securities. If the fund invests 65% or more of its corpus in debt securities, it is taxed like a non-equity fund. Likewise, if the fund invests 65% or more in equities, it is taxed like an equity fund.

Interval Funds is a mutual fund scheme that combines the features of open-ended and closed-ended schemes, wherein the fund is open for subscription and redemption only during specified transaction periods (STPs) at pre-determined intervals. In other words, Interval funds allow redemption of Units only during STPs. Thus between two STPs they are akin to closed-ended schemes and therefore, compulsorily listed on Stock Exchanges. However, unlike typical closed-ended funds, interval funds do not have a maturity date and hence open-ended in nature. Hence, one may remain invested in an Interval Fund as long as one wishes to like any open-ended schemes. Hence, in a sense, interval funds are akin to Interval funds are typically debt-oriented products, but may invest in equities as well as per the scheme’s investment objective and asset allocation specified in the Scheme Information Document.

Multiple Yield Funds

Multiple yield funds (MYFs) are hybrid debt-oriented funds that invest predominantly in debt instruments and to some extent in dividend-yielding equities.

The debt instruments assist in generating returns with minimum risk and equities assist in long-term capital appreciation. MYFs invest predominantly in debt and money market instruments of short-to-medium-term residual maturities.

Dynamic Bond Funds

DBFs invest in debt securities of different maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the interest rate view of the fund managers. Such funds give the fund manager the flexibility to invest in short- or longer-term instruments based on his view on the interest rate movement. DBFs follow an active portfolio duration management strategy by keeping a close watch on various domestic and global macro-economic variables and interest rate outlook.

Fixed Maturity Plans (FMPs)

FMPs, as the name indicates, have a pre-determined maturity date (like a term deposit) and are close-ended debt mutual fund schemes.FMPs invest in debt instruments with a specific date of maturity, lesser than or equal to the maturity date of the scheme, also enjoy the status of debt funds. After the date of maturity, the investment is redeemed at current NAV and the maturity proceeds are paid back to the investors.

The tenure of an FMP may range from as low as 30 days to 60 months. Since the maturity date and the amount are known beforehand, the fund manager can invest with reasonable confidence, in securities that have a similar maturity as that of the scheme. Thus, if the tenure of the scheme is one year then the fund manager would invest in debt securities that mature just before a year. Unlike in other open-ended funds, where one can buy and sell units from the mutual funds on an ongoing basis), no pre-mature redemptions are permitted in FMPs. Hence, the units of FMPs (being close-ended schemes) are compulsorily listed on a stock exchange/s so that the investors may sell the units through the stock exchange route in case of urgent liquidity needs.

Monthly Income Plans (MIPs)

?MIPs are hybrid schemes that invest in a combination of debt and equity securities, but are typically debt oriented mutual fund schemes, as they invest pre-dominantly in debt securities and a small portion (15-25 per cent) in equities.

MIPs offer regular income in the form of periodic (monthly, quarterly, half-yearly) dividend pay-outs. Hence MIPs are the preferred options for investors seeking steady income flows. Under MIPs, monthly income or regular dividend is neither assured nor is it mandatory for mutual funds to pay at stated intervals, because in a mutual fund scheme, the dividend is paid at the discretion of the mutual fund and is subject to availability of distributable surplus from realized gains.

Due to the equity exposure, MIP returns can be volatile and may suffer losses, making dividend pay-outs irregular - both in quantum and frequency or even skip dividend payment. In spite of this, MIPs have a history of providing higher returns after adjusting for tax and hence can be a better option.

Investors wary of fluctuating income from MIPs' dividend option can opt for Growth Option and a systematic withdrawal plan, or SWP, which allows regular redemption of a pre-determined amount. An SWP under a MIP can work as a regular source of income for investors. SWP works better when a person invests a large sum.

Capital Protection-Oriented Funds

As the name suggests, Capital Protection-Oriented Funds are mutual fund schemes that aim to protect at least the capital, i.e., the initial investment, providing an opportunity to make additional gains, as per the investment objectives of the fund. In short, a Capital Protection-Oriented Funds aims to safeguard the principal amount while offering a potential equity-linked capital appreciation. However, it is important to note that there is no guarantee of returns or guaranteed capital protection.

Capital Protection-Oriented Funds are closed-ended debt funds that typically invest a major portion (say 80%) of the corpus in AAA-rated bonds, and the remaining amount in riskier securities like equity. Some funds may even take exposure to equity derivatives to protect against the downside risk.

It is this very structure that is oriented towards protecting the principal. By the end of the stipulated term, the debt portion of the fund grows to give you back the principal, while the equity portion brings the potential upside. Thus, even if the equity market crashes, the principal amount is protected. Hence, Capital Protection-Oriented Funds are preferred over regular FMPs. Capital Protection-Oriented Funds are ideal for investors who wish to protect their capital against the downside risk and also participate in the equity market.

Note: Mutual funds are subjected to market risks. Please read all scheme related documents carefully before investing.