What is Debt??
Debt is money borrowed (Loan) by one party from another. This is used commonly by many individuals and companies to make large purchases or other business needs that they typically cannot fund themselves. Needless to say, the debt taken has to be paid back typically with interest.
When a company takes a debt, it issues a bond or a debenture to the lender which is typically transferable.
When a Government issues a debt it’s called a Gsec or a Government Security.
When the Government takes a debt for a shorter period, it’s called a treasury bill.
What are Debt Capital Markets?
The debt market consists of various instruments/securities that facilitate the buying and selling of these bonds and Gsecs. Typically volumes in the debt market are larger than in cash equity markets.
Debt is considered to be less risky than equity investments so many investors with a lower risk tolerance prefer buying debt securities. However, debt investments offer lower returns as compared to equity investments.
Debt Mutual Funds
Debt funds invest in securities that generate fixed income such as Corporate Bonds, Commercial Paper, Government Securities, and many other money market (for less duration) instruments.
All these instruments have a pre-decided maturity date and interest rate that the buyer can earn on maturity – hence the name fixed-income securities. The returns are usually less affected by fluctuations in the stock market. Therefore, debt securities are considered to be low-risk investment options.
Nonetheless, the value of these securities fluctuates based on the interest rates in the system. So although bonds are not as volatile as equities their prices move based on economic conditions.
Types of Debt Funds
Given below are the categories of debt funds according to SEBI guidelines
| Overnight Fund | Overnight securities having maturity of 1 day |
| Liquid Fund | Debt and money market securities with maturity of up to 91 days only |
| Ultra Short Duration Fund | Debt & Money Market instruments with maximum duration of the portfolio between 3 months – 6 months |
| Low Duration Fund | Investment in Debt & Money Market instruments with maximum duration portfolio between 6 months- 12 months |
| Money Market Fund | Investment in Money Market instruments having maturity of up to 1 Year |
| Short Duration Fund | Investment in Debt & Money Market instruments with maximum duration of the portfolio between 1 year – 3 years |
| Medium Duration Fund | Investment in Debt & Money Market instruments with maximum duration of portfolio between 3 years – 4 years |
| Medium to Long Duration Fund | Investment in Debt & Money Market instruments with maximum duration of the portfolio between 4 – 7 years |
| Long Duration Fund | Investment in Debt & Money Market Instruments with maximum duration of the portfolio greater than 7 years |
| Dynamic Bond * | Investment across duration |
| Corporate Bond Fund | Minimum 80% investment in corporate bonds only in AA+ and above rated corporate bonds |
| Credit Risk Fund | Minimum 65% investment in corporate bonds, only in AA and below-rated corporate bonds |
| Banking and PSU Fund | Minimum 80% in Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds |
| Gilt Fund | Minimum 80% in G-secs, across maturity |
| Gilt Fund with 10-year constant Duration | Minimum 80% in G-secs, such that the maximum duration of the portfolio is equal to 10 years |
| Floater Fund ** | Minimum 65% in floating rate instruments (including fixed rate instruments converted to floating rate exposures using swaps/ derivatives) |
* Dynamic Bond funds can invest in bonds of different maturities. The fund manager alters the tenor of the securities in the portfolio in line with expectations on movement in interest rates. The tenor is increased if interest rates are expected to go down and vice versa with an aim to increase the return in the fund.
**Floating rate funds invest in bonds whose interest are reset periodically so that the fund earns interest income that is in line with current rates in the market. These funds will give you a higher return if rates in the system go up and give lower return if rates in the system go down.
Liquid funds invest in securities with not more than 91 days to maturity. Investors use these funds in typically to park funds or for emergencies.
Ultra Short-Term Debt Funds hold a portfolio with a slightly higher tenor of bonds to earn higher interest income and accordingly a higher return.
Short-term funds combine interest income earned from a predominantly short-term debt portfolio with some exposure to longer-term securities to benefit from appreciation in price and a better return to the investors.
It helps to keep in mind though that no returns are guaranteed and sometimes funds don’t perform as expected based on market conditions.
Fixed Maturity Plans (FMPs)
– FMPs are closed-ended funds that eliminate interest rate risk and lock in a yield by investing only in securities whose maturity matches the maturity of the fund.
– FMPs create an investment portfolio whose maturity profile matches that of the FMP tenor.
Target Maturity Funds
Similar to fixed maturity plans, target maturity funds are plans that are open-ended and have a fixed maturity date.
TMF can track debt indices like Nifty SDL or Nifty PSU Bond index etc.
Returns are predictable, typically if FMPs & TMFs are held to maturity.
Capital Protection-Oriented Funds
Capital Protection Oriented Funds are close-ended hybrid funds that create a portfolio of debt instruments and equity derivatives
– The portfolio is structured to provide capital protection and is rated by a credit rating agency on its ability to do so. The rating is reviewed every quarter.
Other than overnight funds, all debt funds have to also be evaluated for the credit risk they may take to earn higher interest income. (What this means is that they may buy bonds of entities that are riskier to earn a higher interest.)
A proper evaluation of the issuer entity as well as an overview of the industry as well as the macros in the economy is the fund manager’s responsibility.
The tenor of the securities will define the return and risk of the fund. The longer the tenor is, the riskier it is considered. As mentioned earlier bonds are in effect loans. The longer the tenure of the loans, it is common sense the higher the chance of default hence riskier.
– Funds holding securities with lower tenors have lower risk and lower return.
Why should one invest in a Debt Mutual Fund?
The main reasons that drive investment in debt funds are:
- Professional Expertise and Returns
Investing in a debt fund allows one to earn interest as well as capital gains on debt. It gives retail investors access to money markets and wholesale debt markets, both of which are not easy for them to invest directly.
- Investment Options
Debt funds are offered for the entire maturity and credit risk spectrum. Short-term funds produce consistent and predictable income. Longer-duration funds earn interest as well as capital gains and are appropriate for investors who can tolerate higher NAV volatility. Overnight funds, liquid funds, corporate bond funds, and short-term funds typically invest in more secure debt securities.
- Low Risk
Since debt mutual funds are less risky than equity funds, allocating a portion of an investment portfolio to the best-performing debt funds minimises risk and adds stability.
- Liquidity
These funds are extremely liquid and can be redeemed fast, usually within one or two working days from the redemption request being made. Unlike bank fixed deposits or recurring deposits, there are rarely lock-in or fixed periods. While a few funds may levy a minor exit cost for early withdrawal, in general, there are no or low penalties for withdrawing a mutual fund investment.
Current taxation rules of debt funds
Tax on Debt funds, not hybrid funds (hybrid funds that invest 35%-65% in domestic equity)- all gains are added to the investor’s income and taxed as per his/her slab.
Choose the right Debt Fund based on your preferences…. and Ho jao Shuru!!!
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