Glennor - Since 1979

Debt Funds

What are Debt Mutual Funds?

There are different types of Mutual Funds that invest in various securities, depending on their investment strategy.

Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest.

The returns of a debt mutual fund comprises of -

  • Interest income
  • Capital appreciation / depreciation in the value of the security due to changes in market dynamics

Debt securities are also assigned a 'credit rating', which helps assess the ability of the issuer of the securities / bonds to pay back their debt, over a certain period of time. These ratings are issued by independent rating organisations such as CARE, CRISIL, FITCH, Brickwork and ICRA. Ratings are one amongst various criteria used by Fund houses to evaluate the credit worthiness of issuers of fixed income securities.

There is a wide range of fixed income or Debt Mutual Funds available to suit the needs of different investors, based on their:

  • Investment horizon
  • Ability to bear risk

Different Types of Debt Funds

There are different types of Debt Mutual Funds that invest in various fixed income securities of different time horizons. Some of the debt based & blended category products (which have both debt and equity allocation) are as follows -

Liquid Funds / Money Market Funds

These funds invest in highly liquid money market instruments and provide easy liquidity. The period of investment in these funds could be as short as a day. They aim to earn money market rates and could serve as an alternative to corporate and individual investors, for parking their surplus cash for short periods. Returns on these funds tend to fluctuate less when compared with other funds.

Ultra Short Term Funds

Earlier known as Liquid Plus Funds, they invest in very short term debt securities with a small portion in longer term debt securities. Most ultra short term funds do not invest in securities with a residual maturity of more than 1 year. Also referred to as Cash or Treasury Management Funds, Ultra Short Term Funds are preferred by investors who are willing to marginally increase their risk with an aim to earn commensurate returns. Investors who have short term surplus for a time period of approximately 1 to 9 months should consider these funds.

Floating Rate Funds

These funds primarily invest in floating rate debt securities, where the interest paid changes in line with the changing interest rate scenario in the debt markets. The periodic interest rate of the securities held by these products is reset with reference to a market benchmark. This makes these funds suitable for investments when interest rates in the markets are increasing.

Short Term & Medium Term Income Funds

These funds invest predominantly in debt securities with a maturity of upto 3 years in comparison to a Regular Income Fund. These funds tend to have a average maturity that is longer than Liquid and Ultra Short Term Funds but shorter than pure Income Funds. These funds tend to perform when short term interest rates are high and could potentially benefit from capital gains as liquidity comes back to the market and interest rates go down. These funds are suitable for conservative investors who have low to moderate risk taking appetite and an investment horizon of 9 to 12 months.

Income Funds, Gilt Funds and other dynamically managed debt funds

These funds comprise of investments made in a basket of debt instruments of various maturities & issuers. These funds are suitable for investors who willing to take a relatively higher risk as compared to corporate bond funds,and have longer investment horizon. These funds tend to work when entry and exit are timed properly; investors can consider entering these funds when interest rates have moved up significantly to benefit from higher accrual and when the outlook is that interest rates would decrease. As interest rates go down, investors can potentially benefit from capital gains as well. A few types of dynamically managed debt funds are mentioned below -

  • Income funds invest in corporate bonds, government bonds and money market instruments. However,they are highly vulnerable to the changes in interest rates and are suitable for investors who have a long term investment horizon and higher risk taking ability. Entry and exit from these funds needs to be timed appropriately. The correct time to invest in these funds is when the market view is that interest rates have touched their peak and are poised to reduce.
  • Gilt Funds invest in government securities of medium and long term maturities issued by central and state governments. These funds do not have the risk of default since the issuer of the instruments is the government. Net Asset Values (NAVs) of the schemes fluctuate due to change in interest rates and other economic factors. These funds have a high degree of interest rate risk, depending on their maturity profile. The higher the maturity profile of the instrument, higher the interest rate risk.
  • Dynamic Bond Funds 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. These funds Invest across all classes of debt and money market instruments with no cap or floor on maturity, duration or instrument type concentration.
Corporate Bond Funds

These funds invest predominantly in corporate bonds and debentures of varying maturities that offer relatively higher interest, and are exposed to higher volatility and credit risk. They seek to provide regular income and growth and are suitable for investors with a moderate risk appetite with a medium to long term investment horizon.

Close Ended Debt Funds
  • Fixed Maturity Plans (FMPs) are closed ended Debt Mutual Funds that invest in debt instruments with a specific date of maturity that is less than or equal to the maturity date of the scheme. Securities are redeemed on or before maturity and proceeds are paid to the investors. 

    FMPs are similar to passive debt funds, where the portfolio manager buys and holds the debt securities for the entire duration of the product. FMPs are a good option for conservative investors, as they do not carry any interest rate risk provided the investor stays invested until the maturity of the product. They are also a tax efficient investment option.

Hybrid Funds

They bridge the gap between equity and debt schemes by investing in a mix of equity and debt securities. This adds a considerable amount of risk to the product and will suit investors looking for commensurate returns with higher levels of risk than regular debt funds.

  • Monthly Income Plans (MIPs) strive to offer the benefit of diversification across asset classes by investing a proportion of the portfolio in debt securities (70% to 95%) with a smaller allocation in equity securities (5 % to 30 %). 

    As the correlation between prices of equity and debt is low, this product endeavors to give an investor returns that are relatively higher than debt market returns. MIPs can be classified as debt oriented hybrids that seek to -

    • generate income from the debt securities
    • maximise the benefits of long term growth from equity securities
    • aim for periodic distribution of dividends

    However, an important point to be noted is that monthly income is not assured and it is subject to the availability of distributable surplus in the fund.

  • Capital Protection Oriented Funds are closed ended funds that are hybrid in nature; they allocate money to debt and equity securities. The allocation to debt securities is done in such a way that at the end of the term of the product, the value of debt investment is equal to the original investment in the fund. The equity portion aims to add to the returns of the product at maturity. These funds are oriented towards protection of capital and do not offer guaranteed returns. 

    Say, for example, AAA bonds are quoting at interest rate of 10% p.a. for a 5 year term.

    • This means that at the end of 5 years, the investment of Rs. 100 in such bonds would be worth Rs. 161.05, assuming reinvestment of the interest.
    • On the other hand, if one invests Rs. 62.09 in such bonds, the value of the bonds at the end of 5 years would be Rs. 100.

    In such a case, the allocation between equity and debt would be 38 : 62 respectively. So, if the equity value reduces to zero, the investor gets back the original amount invested.

    The asset allocation is a function of prevailing interest rates on high quality (AAA rated) bonds. It is mandatory for the fund to be rated by at least one rating agency in order to be called a capital protection oriented fund. Debt securities held in the portfolio must be of highest rating.

  • Multiple Yield Funds are close ended income funds that aim to optimize income from debt securities and potential growth from equity. They aim to limit the downside by investing in rated debt instruments of reputed issuers. Through a limited equity exposure, they aim to provide capital appreciation by investing in shares of companies without any sector or market capitalization bias. This exposure will help to participate in the growth of these companies thus seeking to provide the portfolio with an element of potential long term capital appreciation. 

How to choose a Debt Fund?

It's important for you to consider the following while choosing an appropriate Debt Mutual Fund -

Stated investment horizon
Maturity profile
Credit rating profile
Asset allocation in Fund Portfolio
Other quantitative indicators

This information is available in Mutual Fund Factsheet's that are uploaded every month on the websites of Asset Management Companies.

Stated Investment Horizon

Debt Mutual Fund generally specify an investment horizon, for which investors should consider investing. This is an important parameter that is sometimes overlooked by investors, who remain invested for long periods without considering the market factors. The specific investment horizon should be looked at to aim for optimum risk adjusted returns in the debt fund.

Maturity Profile

It is a graphical representation of the maturity of all holdings of the funds portfolio. It gives an over all picture as to what percentage of the funds net assets fall under different time frames, ranging from 6 months to 1 year to 3 years and so on. This helps understand what percentage of the funds assets invest in which maturity bonds, and to what extent the fund is exposed to the interest rate risk. In a falling interest rate scenario, debt funds maintain relatively higher portfolio maturities and vice versa.

The image above is representational of the maturity profile of a debt fund, as presented in a mutual fund fact sheet.

Credit Risk and Credit Rating Profile

Debt Mutual Funds can invest in securities with different credit ratings, as per the schemes investment strategy. The credit rating of the security is listed alongside its name in the mutual fund factsheet. These ratings are assigned by different rating agencies and indicate the credit worthiness of the borrower. Higher the rating, high is the creditworthiness of the borrower, although the returns may be lower as compared to a bond issued by an entity that has a lower rating. The Credit profile of the debt portfolio indicates the level of credit risk that the debt fund has assumed. A large chunk in sovereign papers or highest rating papers implies that the fund is taking lower credit risk.

The image above is representational of the rating profile of a debt fund, as presented in a mutual fund fact sheet.

Asset Allocation in Fund portfolio

This helps investors understand the investment approach of the fund manager. Debt funds invest in bonds issued by different entities and investors can identify the percentage of the fund's portfolio that is invested in the various debt instruments like government of India bonds, state government bonds, corporate debt, public sector undertaking (PSU) bonds, treasury bills, cash etc.

In a fund portfolio, one can see list of instruments that the fund has invested in. While this will vary continually with the buying or selling calls taken by the fund manager, the portfolio can be indicative of the strategy employed by the fund.

A larger exposure to Government of India securities would imply a potential for greater returns in a falling interest rate scenario (as bond prices and interest rates are inversely related). Investments in good Corporate and PSU bonds have the potential to earn higher interest income than the investments in pure government of India bonds. A certain percentage of the portfolio is also held in cash and net current assets. This is done to ensure availability of funds to meet the day-to-day redemptions of investors without having to sell securities which might affect the portfolio's performance.

Other Quantitative Indicators of debt Mutual Funds

Average maturity of the portfolio: This figure, represented in day or years, gives the average maturity of all the instruments held in the portfolio.

Duration of portfolio: The duration (not to be confused with maturity) is the measure of the price sensitivity of the portfolio to a change in interest rates. Funds with a longer duration would be more sensitive to a given change in interest rates. For example, if interest rates were to go down (or up) by 1% in a month, the Net Asset Value (NAV) of Bond fund is likely to go up (or down) by 5 per cent if modified duration of portfolio is mentioned as 5 years.

Yield: The yield is a measure of the interest income generated by the bonds in the portfolio. Funds that invest in bonds that have a higher coupon rate would have a higher portfolio yield. In a stable interest rate scenario, this can be considered as an approximate measure of the returns the fund can generate. However, in a falling interest rate scenario, this is not a true measure of the returns, as it does not account for trading gains that can accrue from the active buying and selling of bonds. The yield to maturity of a debt fund indicates the running yield of the fund. Debt funds are total return products returning both accrual of interest and mark to market gain or losses.

Other than above, investors must also look at the stated investment objective of the debt fund, its positioning in the style box, other fund features section and its performance record over a period of time vis-a vis its benchmark.

The points listed below, provide a snapshot of the parameters to consider while deciding in which Debt Mutual Fund to invest.

  • The debtfund Portfolio gives a list of the instruments the fund has currently invested in, indicative of its investment strategy.
  • Average portfolio maturity indicates the length of time until the principal amount of the bond is repaid.
  • Duration of the portfolio indicates the price sensitivity of the portfolio to a given change in interest rates; a measure of the fund's volatility.
  • Average maturity and duration fluctuate depending on the view of the fund manager for flexible and dynamic debt funds. A fund with higher maturity and duration is expected to yield better results in a falling interest rate scenario and vice versa. This is because interest rates and bond prices are inversely related and longer the tenure of the bond, the more sensitive it is to changes in interest rates.
  • The yield is a measure of the interest income earned on the bonds held in the portfolio.
  • The maturity profile of the portfolio can be used to understand the composition of the portfolio.
  • Returns can potentially enhanced by lowering credit quality of the portfolio, which enhances the credit risk. The rating profile can be used to understand the credit risk.