A Complete Guide to Debt Mutual Funds

Two of the biggest categories of financial assets are – Debt and Equity. While Equity is something I have now understood fairly well over a few years and also written about, the Debt category is one that I have really understood more with this new role of being an Investment Counsellor. While debt is synonymous with Fixed Income category too, I think most investors do not understand this asset. This post is meant to act as a primer for education on the basics of Debt and the type of products for the kind of need.

What is Debt?

Credit or lending is one of the oldest financial action in human history. In fact, as Yuval Noah Harari puts it in his fantastic book Sapiens, it is this trust of lending money in the expectation of building something not seen (like a café with future profits). Today too, credit or debt is one of the main ways in which the economy grows as well rolls over money. The debt category depends on this movement of money, from surplus to being used to build something at the cost of interest being paid out to the lender.

How is Debt different from Equity?

Debt is lower risk and lower return than Equity. However, it is important to understand just why is it so.

Lower risk

Debt is an investment with an agreement on pre-defined terms. So, if a company borrows money from the public by issuing a bond, the rate of interest is pre-defined. On the other hand, when the same company lists a part of it’s equity ownership on the stock exchange, the rate of return on that share depends on the performance of the company, the profits it generates and the future forecast for the company.

In essence, you are a lender with debt investments while you are the owner of a microscopic part of the company with equity investments. So, while you can expect the range of the interest rate you can get from your debt investments giving it lower risk, the unpredictability of the company performance makes equity more risky.

Lower Returns

While debt investments come with lower risk, simultaneously they also end up giving lower returns. With debt investments, the lender is on a fixed agreement and even with any upswing in profitability, there is no benefit. On the other hand, as an equity share holder, any future profit potential for the company adds in to the returns.

Why invest through debt funds?

Like stocks and equity mutual funds, in debt too a lot of investors do invest directly through government or corporate bonds and NCDs (Non Convertible Debentures). However, in debt, mutual funds might be a smarter option for the following reasons:

Diversification

Within debt mutual funds, an investor ends up holding multiple commercial papers or bonds or NCDs of the chosen category. Considering how some companies in the recent past have gone bust and ended up defaulting on payments to their lenders, diversification in debt assets is a pertinent need.

Favourable taxation

With bonds and NCDs, any interest or coupon is treated as regular income. On the other hand, with debt mutual funds, for any investment held for more than three years, the gains get the benefit of indexation through the cost inflation index numbers. You can read about it in more detail in this post on capital gains tax.

Better liquidity

For most debt instruments today, secondary market is quite limited. So, if you have subscribed to a bond at the time of launch and want to off load it before maturity, finding buyers for it is a difficult task. On the other hand, debt mutual funds are more liquid and easier to encash when the need arises.

Some terms to know about debt funds

Average maturity

This is the main factor on the basis of which the category of debt funds are based. Average maturity refers to the term of the debt assets held. So, if a debt fund holds 20 debt assets, the average period of maturity on those papers is what would be captured by average maturity.

Yield to maturity

Every debt asset comes with a rate of interest which would be realized when held to maturity. Yield to maturity is a number that captures the rate of interest that the debt assets in the fund would yield when held to maturity.

Credit rating

Credit rating is the unbiased third party analysis of debt repayment ability of an organization. So, if company X is borrowing money through a bond or NCD, and a rating agency like CRISIL or ICRA believes that it is a very safe company that is bound to pay back its’ debt, it would be rated at the highest level of AAA+. With credit rating, higher the rating, safer the debt asset though it also means a lower yield. Goernment bonds are considered the safest because it is assumed that the government will not defaut in its’ debt repayments. For a debt fund, it is important to know what percentage of their holdings are in AAA, AA and A rated papers.

Types of Debt Funds

Fixed Maturity Plans or Close Ended Funds

These are funds which hold on to a set of papers till maturity and are available to investors only for a limited period window. While investing it in, an investor knows the range of returns that they could expect through a figure called yield to maturity, which is the fixed rate of interest on the papers held. Investors automatically get the maturity amount at the end of the period in this case. If the maturity period is more than three years, they also get the benefit of indexation.

Open Ended Debt Funds

Open ended debt funds are those in which an investor can enter and exit at any point in time. There are a number of different categories to be aware of and all of them are based on the maturity period of the debt instruments held by the fund. Knowing the maturity period and the category of the fund is key to making appropriate decisions depending on the purpose and the time period. These funds too get the benefit of indexation when held for more than three years.

Types of Open Ended Debt Funds

On the basis of average maturity

When the average maturity increases, while the rate of interest is higher, it is also that much more prone to interest rate volatility. Over a longer period, interest rates are liable to change and an investor could be caught on the wrong side of the interest spectrum when investing in longer term instruments.

Fund category Duration
Overnight funds 1 day
Liquid funds Less than 91 days
Ultra short funds 3 – 6 months
Low duration funds 6 – 12 months
Money market funds Up to 1 year
Short duration funds 1 – 3 years
Medium duration funds 3 – 4 years
Medium to long duration funds 4 – 7 years
Long duration funds More than 7 years
Dynamic bond fund Across durations

Personally, I believe long term funds end up opening themselves to far too much volatility and medium term or dynamic bond funds work better for even long term investing in debt. To park your emergency funds, anything less than six months is a good bet which then incudes liquid funds and ultra-short funds.

On the basis of type of papers

Some funds are so categorized on the basis of their underlying debt assets that they are to invest in. As per the SEBI Mandate, funds must invest atleast 80% of their assets into the category of debt papers that they fall under. For instance, a Gilt fund would have to invest atleast 80% in government bonds and can look to diversify with only the remaining 20%.

Fund category Type of debt assets
Corporate bond funds Highest rated corporate bonds
Credit risk funds Below highest rated corporate bonds
Banking and PSU funds Debt instruments of banks and PSUs
Gilt funds Government securities
Gilt funds with 10 years constant duration Only 10 year government securities
Floater funds Floating rate instruments

 While initially, debt might come across as somewhat complex, apart from Equities it’s the other biggest asset class and a must in your portfolio for diversification.

Do you invest in debt funds? What has your experience been? Let me know in the comments below.

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