Debt mutual funds are ideal investment options for investors for short term investments. Their risks are much lower than equity or equity oriented funds, they have the potential to generate superior returns compared to traditional fixed income products and they enjoy a significant tax advantage over bank savings and Fixed Deposits.
What are debt funds?
Debt mutual funds invest in debt and money market securities. Money market securities include commercial papers, certificate of deposits, treasury bills etc, while debt securities include Government and Corporate bonds. We should be aware of the fact that unlike bank FDs or Government Small Savings Schemes, debt mutual funds are subject to risks. There are two main risk associated with these funds:-
- Interest rate risk. It refers to change in price of the debt instrument with changes in interest rates(based on Repo rate as decided by RBI from time to time). As far as interest rate risk is concerned, it is directly related to the maturity profile of the underlying securities. Maturity is the time period at the end of which the issuer (borrower) will pay back the face value (principal amount) to the investor. So the debt instrument is price sensitive to its maturity duration due to changes in interest rate. If the duration of a debt instrument is 3 years, then for every 1% change in interest rate, the price will change by approx 3%. As a thumb rule, debt instruments have an inverse relationship with interest rates; if interest rate falls, price of the debt instrument rises and vice versa.
- Credit risk. If the issuers of the debt instruments (the borrower) do not meet their debt payment obligations(interest and principal amount), it amounts to credit risk. Credit ratings assigned to debt instruments by credit rating agencies are a measure of credit risk. It is important for us to note that if a debt instrument is held till maturity, then price change will have no effect on returns. That is why in the current debt market cycle, accrual based short term debt funds may be a good option.
What are the debt funds one should consider and why?
Liquid, Ultra short term debt funds employ accrual strategy to reduce interest rate risk by holding securities in their portfolios till maturity. They earn primarily coupon rate of the debt instruments. On the other side, income, Gilt and other dynamically managed debt funds perform based on interest rate cycles. Lets see different types of debt funds.
Liquid Funds: Liquid funds are money market mutual funds, where the residual maturity of portfolio securities do not exceed 91 days. Redemption requests are processed within 1 day and money credited to the investors’ bank account on the next business day. These funds do not have any exit load, which means that we can redeem our investments partially or fully at any time without paying penalty. Liquid funds are comparable to our savings bank account from liquidity perspective. In the last one 1 year, average liquid fund category return was 6.5%, much higher than savings bank interest rate.
Ultra short duration 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 may consider these funds.
Short duration Funds: These funds invest predominantly in debt securities with a maturity of up to 3 years. 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 . These funds are suitable for investors who are willing to take a relatively higher risk 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.
Therefore, effective tax rate on actual cash profit is only 8.1% as compare to much higher figures in case of bank FD( 30% tax on accrued interest if we are in 30% tax slab)
1. We discussed different types of debt funds; investments can be planned based on investment needs.
2. Debt mutual funds enjoy considerable tax advantage over traditional fixed income schemes, when invested over long tenors (3 years plus).