Debt funds
Several options are available for investing money. Popular among them are a few fixed income generating instruments. Mutual funds are one of those tools which cater to the needs of investors according to their risk and return appetite. There are equity funds, fixed income funds, hybrid funds etc. Among them are debt funds, also known as income funds or bond funds. It is a mutual fund scheme that invests in fixed income instruments like corporate and Government bonds, money market instruments, corporate debt securities,treasury bills, commercial paper etc. They carry lower risk than equity funds as they earn a fixed interest. And by investing primarily in these opportunities, debt mutual funds reduce the factor by a huge margin. Debt mutual funds earn better than fixed deposits if not high returns.
The investors who are risk-averse and prefer regular income should consider debt funds. Debt funds provide stable returns against a low cost structure. They are considered to be safer and are highly liquid. As compared to Bank fixed deposits, these funds offer better returns and are less volatile at the same time. Debt funds offer capital appreciation over a longer period. They are tax-efficient too because tax liability arises only in the year of redemption. In case you earn long term capital gains by selling them, you are entitled to indexation benefits as well.
The mechanism is like lending money to the entity issuing the instrument. The interest rate is pre-decided along with the maturity period. Debt funds invest in a variety of securities, based on their ratings. The risk of default in disbursing the returns is depicted by the credit rating. The fund manager of a debt fund ensures investment in high rated credit instruments. High credit rating means that the entity is more likely to pay interest and pay back the principal upon maturity.
There are different kinds of debt funds and investors can choose from them according to their own choice. Maturity period plays a major role while choosing them. Following are the types of debt funds:
- Fixed Maturity Plans-Fixed Maturity Plans come with a lock-in period. And you can select from them but mostly investing in them is possible only during the initial offer period, further investments in such schemes are not possible. FMPs have a duration of a few months or years.They can be compared with FDs but FDs promise fixed returns, whereas FMPs don’t guarantee high returns. They are most likely to earn better than FDs. They are better in terms of tax-efficiency. These funds invest in fixed income securities such as corporate bonds and government securities. FMPs are closed ended debt funds.
- Short, medium and long term funds– Short term debt funds are with a maturity period of 1-3 years. The interest rate risk is less for this category and the prices are not much impacted by interest-rate movements. Medium term funds have a maturity period of 5 years. Long term funds come with a period of more than 5 years. Both of them are relatively riskier than short term funds as they are of longer duration, they are subjected to interest rate fluctuations. This is known as interest rate risk or duration risk. The maturity period is associated with the money market securities in a way so that the Macaulay duration of the scheme matches with the duration of the funds.
- Liquid Fund-This kind of fund invests in money market instruments having a maturity of maximum 91 days. They are better than short term investments and earn more than savings accounts. Due to the short duration involved they are almost risk-free. Many mutual fund companies offer instant redemption on liquid fund investments through unique debit cards. The main advantage of this fund is felt by those investors who have surplus to park in an income generating investment. Only very highly rated instruments are invested in through liquid funds.
- Dynamic Bond Funds-The portfolio composition changes as per the fluctuating interest rate regime. They have different average maturity periods and take interest rate calls. They invest in instruments having both short term and long term maturities. They are ideal for investors who are not experts in making the right calls based on the interest rate movement. Investors with moderate risk appetite and investment horizon of 3-5 years should invest in these funds. The main objective of dynamic funds is to provide ‘optimal’ returns in both rising and falling market conditions. Dynamic bond funds are perhaps the excellent alternative for those who want to ride the interest rate cycles.
- Credit Opportunities Funds-These funds aim to earn higher returns. Credit risk is more as COFs hold lower rated funds which come with higher interest rates. Investment is not made as per the maturities of debt instruments. They are relatively newer kinds of debt funds and are considered to be comparatively risky. Fund managers invest in instruments rated under “AA” anticipating them to rise and become higher rated over time and thereby increase in value.
- Gilt fund-Gilt funds invest 80% of their corpus in government securities across varying maturities. They all are high rated securities with very low credit risk. Government always pays off the loan it takes in the form of debt instruments, hence gilt funds are an ideal option for those who seek fixed income with minimum amount of risk.
- Income Funds-These funds take a call on the interest rates and invest mainly in debt securities with extended maturities. Income funds typically have an average maturity of 5-6 years. They are better than dynamic bond funds in terms of stability. They are a type of debt mutual fund that attempts to provide a stable rate or return in all market scenarios through active portfolio management. Income funds also face the risk of generating negative returns.
There are other debt funds too with a shorter duration of maturity period, such as:
- Overnight Funds-They have a one day maturity period.
- Ultra-Short Duration Funds-These funds mature within a period of 3-6 months.
- Low Duration Fund-Maturity period is 6-12 months.
- Corporate Bond funds invest in corporate bonds and Banking & PSU Funds invest in PSUs,PFIs.
Just like duration of debt funds, interest rates earned also have an impact on them. There is a relation between debt price/NAV and interest rate. Let’s study how they are correlated.
Interest Rate Risk
Interest rate risk is among the primary risks faced by the investors while investing in debt funds.
There is an inverse relationship between the NAV of debt funds and interest rate and should be understood by the investors. A bond fund is a bunch of funds. When interest rates go up, the return from the new bonds will be higher. And because of this factor, the bond prices of such bonds held by the bond fund will go down in value. Now the reverse will be the case when interest rates go down. The bond prices will go up in value when the interest rate comes down because they will earn the benefit from higher interest rates till the expiry of these bonds held by the bond fund.
When interest rates go down, bonds with longer maturity periods tend to benefit more. They also get negatively impacted when the rates go up. This is a one time event. But whenever the interest rate changes, the bond fund will be affected. If interest rates keep on fluctuating, the current yield on the existing bonds will also change. Thus, bond funds either get appreciation or depreciation on the bond that they hold. The interest rate goes up or down as per the prevailing interest rates and could have a one time impact and also a continuing impact depending upon the interest rate.
Interest rate risk is the potential risk for investment losses that result from a change in interest rates. Interest rate movement creates a risk for debt mutual fund investors. Interest rates rise when the economy is growing. When there is an economic slowdown, the rates will fall. Bonds with longer maturity face greater degree of price volatility. Interest rate risk is applicable to all debt funds, just that a few of them get more affected.
A few examples are given here to make the above explanation more clear-
- A bond pays a fixed rate of 6% and has a par value of Rs.1000. The prevailing interest rates are also @ 6%. If the interest rate starts to rise and becomes 8%, the value of these bonds will fall because if some different bonds are fetching 8%, nobody would like to get 6% bonds. Investors will switch to investments that reflect a higher interest rate.
- An investor buys a five year Rs. 500 bond with 4% interest rate. The rates rise to 5%. Now he will not be able to sell those bonds easily as bonds with higher rates are available. This will result in a lower demand for old bonds and their rates will fall. The market value of the bond may even drop below their original purchase price. But when the rates fall below 5%, the investor is in a better position as the newly issued bonds will yield lesser returns. Hence the old bonds will be more in demand and hence their price will go up.
How does the interest rate risk affect a mutual fund investor’s decision?
An investor should select debt funds based on their individual risk appetite. Interest rate changes can affect many investments but it has more impacts on the value of bonds and other fixed income securities most directly.There is a direct linkage between investment tenure and interest rate risk. Very short duration funds like overnight and liquid funds have very low interest rate risk. A risk averse investor should go for short, very short or highly liquid debt funds.
Similarly concentration in a particular fund will also decide the degree of risk. If your portfolio is diverted more towards a specific bond, higher is the risk. Because if it defaults, the NAV of that particular fund falls.
Thus, it is not necessary that debt mutual funds may always give positive returns and interest rate risk is the main cause behind it. If the interest rates rise, the cost to the issuers of bonds will increase as they need to pay higher interest. They prefer to issue shorter duration bonds so that higher cost is to be borne only for a shorter period. So during such periods, there is more supply of short term bonds. And when interest rates are expected to fall, longer maturity bonds are in demand. Because in a falling interest rate scenario the mutual funds make higher returns from capital gains and in a rising rate scenario they make higher returns from accruals.
Interest rate risk can be reduced by holding bonds of different durations and it may further be managed by hedging fixed-income investments with interest rate swaps, options or other interest rate derivatives.Bondholders should be aware of interest rate changes and make their decisions only after understanding the perceived interest rate fluctuations over time.
How does the time factor/duration work?
Liquid funds carry a low interest rate risk whereas the gilt funds carry a higher amount of risk due to their longer duration. Price sensitivity takes place at a decreasing rate. Longer the duration, more the sensitivity. There will be a rise in bond prices proportional to the residual maturity of a debt fund meaning number of years left for the bonds to be redeemed.
Let us assume that there is a bond that pays out interest at a rate of 10% a year. The interest fell due to a downfall in the economy and newer bonds started getting issued at 9%. Bond prices will rise in that case. If there are two such bonds, one with a one year residual maturity and the other one with a five years of residual maturity, the latter will have a greater demand than the former. The reason is bond with the longer residual maturity would benefit from its higher coupon(interest rate) for a longer period of time.
Duration can measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. It also shows how long it takes in terms of number of years for an investor to be repaid the bond’s price by the bond’s total cash flows. The higher the duration, the more a bond’s price will drop as interest rate risk rises.
For example, There are two types of bonds, type A and type B. Type A matures in one year and type B in ten years. When the interest rates rise, the investor with type A bonds will be able to redeem them and get other bonds with a better interest rate. But the investor with type B bonds will get stuck for ten years. The longer a bond’s time to maturity, the more its price declines relative to a given increase in interest rates.
In crux, we can say that short term or low duration funds yield interest income though there shall be a drop in their debt price. This is further explained in the following paragraphs.
The duration of a debt fund measures the extent to which the value of a fund fluctuates in response to changes in market interest rates. The formula to calculate duration is complex but you can simply understand it by looking at the maturity of a debt fund. The funds holding short-term securities have lower durations. Short term duration funds are expected to have durations between 1-3 years. They carry a lower interest rate risk than medium and long duration funds but higher than liquid and ultra short duration funds.
Usually the investors select funds based on near-term performance of a fund. Gilt funds carry a higher interest rate risk and often underperform. It is believed that gilt or credit or dynamic bond funds earn more income but short-duration debt funds have proved to be more consistent when it comes to returns. When returns are adjusted for the volatility, the risk-adjusted returns in short-term funds are higher than those of gilt funds or dynamic funds. There is a higher risk in dynamic or credit risk funds. They might end up paying almost equal returns over longer term periods. So there is no point in keeping your money invested for a number of years. Rather invest them for a shorter period, earn good interest and use the money again to invest them somewhere else.
The Maturity Risk Premium
It should be noted that usually a long-term bond offers a maturity premium in the form of a higher built-in rate of return to compensate for the additional risk of interest rate changes over a period. As the duration is longer, the interest rate risk is more. To compensate the investors against higher risk, the expected rates of return on longer-term securities are higher than on short-term securities.
The preferred habitat theory says that there is a term structure hypothesis. Bond investors prefer a particular maturity length over the other and they buy bonds outside of their maturity preference if risk premium and other maturity ranges are available. Investors prefer short term bond funds over the longer term ones and that is also the reason why yields on long term bonds should be higher than short term bonds.
Investors have started preferring low-duration and ultra short term funds in India expecting hikes in policy rates by RBI in the near future. Those with a shorter investment horizon find them attractive to meet their investment goals. If inflation continues to rise, RBI may choose an accommodative stance to support growth.
For a few other investors the returns of the liquid funds are not very attractive. Short duration funds provide stable returns at lower volatility, which reflects on their debt price. Rate hike brings debt funds further down. However, the short term debt funds do not get affected much by rate hikes as they are meant for a very short time and get liquidated soon. So if we talk about the debt prices of the low duration funds, they are only marginally affected as compared to gilt funds and other long term funds as the NAV of those funds goes down due to rate hikes.
The investment goals should be the ultimate guiding factor for any investor. If able to earn good returns during a short period, a low debt price might not matter much as long as the short term debt funds offer good returns and liquidity. The strategy behind sticking to these funds should not be changed because of changes in rates. This is equally applicable to investors who choose long term funds. One can take risk by investing in long term debt funds and depending upon the interest rate fluctuations, might end up earning capital gains as well. But in a rising rate scenario, the selling price will go down, dragging the demand for such funds below the newly issued debt bonds.
Funds which invest in lower rated instruments can give higher returns than funds with high credit quality profiles because lower rated instruments give higher yields than highly rated instruments. Interest rate risk can be mitigated by extending the investment tenure but credit risk cannot be avoided. It should be noted that interest rate risk is temporary while credit risk is permanent. In the current economic environment, it is important to know the credit risk as well of your investment and before arriving at a final decision.
All those who want to invest in debt funds should learn about the investment horizon, returns, tax liability and related risks. You can also talk to advisors, market analysts and invest as per your risk taking ability, investable amount and other preferences. You may choose to invest via lump sum investing or Systematic Investment Plan investing.Fixed Maturity Plans cannot be availed through the SIP method though. Due to the benefits offered by debt mutual funds because of their capability to earn higher returns, tax benefits, tax efficiency,liquidity etc. they are very popular.
Bhoi Smrutirekha Dharanidhar