Two of the biggest categories of financial\nassets are \u2013 Debt and Equity. While Equity is something I have now understood\nfairly well over a few years and also written about, the Debt category is one\nthat I have really understood more with this new role of being an Investment\nCounsellor. While debt is synonymous with Fixed Income category too, I think\nmost investors do not understand this asset. This post is meant to act as a\nprimer for education on the basics of Debt and the type of products for the\nkind of need.<\/p>\n\n\n\n
Credit or lending is one of the oldest\nfinancial action in human history. In fact, as Yuval Noah Harari puts it in his\nfantastic book Sapiens, it is this trust of lending money in the expectation of\nbuilding something not seen (like a caf\u00e9 with future profits). Today too,\ncredit or debt is one of the main ways in which the economy grows as well rolls\nover money. The debt category depends on this movement of money, from surplus\nto being used to build something at the cost of interest being paid out to the\nlender.<\/p>\n\n\n\n
Debt is lower risk and lower return than\nEquity. However, it is important to understand just why is it so.<\/p>\n\n\n\n
Debt is an investment with an agreement on\npre-defined terms. So, if a company borrows money from the public by issuing a\nbond, the rate of interest is pre-defined. On the other hand, when the same\ncompany lists a part of it\u2019s equity ownership on the stock exchange, the rate\nof return on that share depends on the performance of the company, the profits\nit generates and the future forecast for the company. <\/p>\n\n\n\n
In essence, you are a lender with debt\ninvestments while you are the owner of a microscopic part of the company with\nequity investments. So, while you can expect the range of the interest rate you\ncan get from your debt investments giving it lower risk, the unpredictability\nof the company performance makes equity more risky.<\/p>\n\n\n\n
While debt investments come with lower\nrisk, simultaneously they also end up giving lower returns. With debt\ninvestments, the lender is on a fixed agreement and even with any upswing in\nprofitability, there is no benefit. On the other hand, as an equity share\nholder, any future profit potential for the company adds in to the returns. <\/p>\n\n\n\n
Like stocks and equity mutual funds, in\ndebt too a lot of investors do invest directly through government or corporate\nbonds and NCDs (Non Convertible Debentures). However, in debt, mutual funds\nmight be a smarter option for the following reasons:<\/p>\n\n\n\n
Within debt mutual funds, an investor ends\nup holding multiple commercial papers or bonds or NCDs of the chosen category.\nConsidering how some companies in the recent past have gone bust and ended up\ndefaulting on payments to their lenders, diversification in debt assets is a\npertinent need.<\/p>\n\n\n\n
With bonds and NCDs, any interest or coupon\nis treated as regular income. On the other hand, with debt mutual funds, for\nany investment held for more than three years, the gains get the benefit of\nindexation through the cost inflation index numbers. You can read about it in\nmore detail in this post on capital gains tax.<\/p>\n\n\n\n
For most debt instruments today, secondary\nmarket is quite limited. So, if you have subscribed to a bond at the time of\nlaunch and want to off load it before maturity, finding buyers for it is a\ndifficult task. On the other hand, debt mutual funds are more liquid and easier\nto encash when the need arises.<\/p>\n\n\n\n
This is the main factor on the basis of\nwhich the category of debt funds are based. Average maturity refers to the term\nof the debt assets held. So, if a debt fund holds 20 debt assets, the average\nperiod of maturity on those papers is what would be captured by average\nmaturity.<\/p>\n\n\n\n
Every debt asset comes with a rate of\ninterest which would be realized when held to maturity. Yield to maturity is a\nnumber that captures the rate of interest that the debt assets in the fund\nwould yield when held to maturity.<\/p>\n\n\n\n
Credit rating is the unbiased third party\nanalysis of debt repayment ability of an organization. So, if company X is\nborrowing money through a bond or NCD, and a rating agency like CRISIL or ICRA\nbelieves that it is a very safe company that is bound to pay back its\u2019 debt, it\nwould be rated at the highest level of AAA+. With credit rating, higher the\nrating, safer the debt asset though it also means a lower yield. Goernment\nbonds are considered the safest because it is assumed that the government will\nnot defaut in its\u2019 debt repayments. For a debt fund, it is important to know\nwhat percentage of their holdings are in AAA, AA and A rated papers.<\/p>\n\n\n\n
These are funds which hold on to a set of\npapers till maturity and are available to investors only for a limited period\nwindow. While investing it in, an investor knows the range of returns that they\ncould expect through a figure called yield to maturity, which is the fixed rate\nof interest on the papers held. Investors automatically get the maturity amount\nat the end of the period in this case. If the maturity period is more than\nthree years, they also get the benefit of indexation.<\/p>\n\n\n\n
Open ended debt funds are those in which an\ninvestor can enter and exit at any point in time. There are a number of\ndifferent categories to be aware of and all of them are based on the maturity\nperiod of the debt instruments held by the fund. Knowing the maturity period\nand the category of the fund is key to making appropriate decisions depending\non the purpose and the time period. These funds too get the benefit of\nindexation when held for more than three years. <\/p>\n\n\n\n
When the average maturity increases, while\nthe rate of interest is higher, it is also that much more prone to interest\nrate volatility. Over a longer period, interest rates are liable to change and\nan investor could be caught on the wrong side of the interest spectrum when\ninvesting in longer term instruments. <\/p>\n\n\n\n
\n Fund category<\/strong>\n <\/td>| \n Duration<\/strong>\n <\/td><\/tr> | \n Overnight\n funds\n <\/td> | \n 1 day\n <\/td><\/tr> | \n Liquid funds\n <\/td> | \n Less than 91\n days\n <\/td><\/tr> | \n Ultra short\n funds\n <\/td> | \n 3 – 6 months\n <\/td><\/tr> | \n Low duration\n funds\n <\/td> | \n 6 – 12 months\n <\/td><\/tr> | \n Money market\n funds\n <\/td> | \n Up to 1 year\n <\/td><\/tr> | \n Short\n duration funds\n <\/td> | \n 1 – 3 years\n <\/td><\/tr> | \n Medium\n duration funds\n <\/td> | \n 3 – 4 years\n <\/td><\/tr> | \n Medium to\n long duration funds\n <\/td> | \n 4 – 7 years\n <\/td><\/tr> | \n Long duration\n funds\n <\/td> | \n More than 7\n years\n <\/td><\/tr> | \n Dynamic bond\n fund\n <\/td> | \n Across\n durations\n <\/td><\/tr><\/tbody><\/table>\n\n\n\n | Personally, I believe long term funds end\nup opening themselves to far too much volatility and medium term or dynamic\nbond funds work better for even long term investing in debt. To park your\nemergency funds, anything less than six months is a good bet which then incudes\nliquid funds and ultra-short funds. <\/p>\n\n\n\n On the basis of type of papers<\/h4>\n\n\n\nSome funds are so categorized on the basis\nof their underlying debt assets that they are to invest in. As per the SEBI\nMandate, funds must invest atleast 80{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} of their assets into the category of\ndebt papers that they fall under. For instance, a Gilt fund would have to\ninvest atleast 80{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} in government bonds and can look to diversify with only the\nremaining 20{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886}.<\/p>\n\n\n\n
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