Are you feeling the pressure of market volatility, uncertain economic conditions, and the constant struggle to strike a balance between risk and returns in your investment portfolio? The quest for financial security often leads investors to search for alternatives that provide a stable income stream without compromising on safety.
In the pursuit of a solution, many turn to debt funds. These financial instruments focus on fixed-income assets like bonds, debentures, treasury bills, and commercial papers.
In this blog, we’ll learn about debt funds, their pros, and cons and also take a look at basket bonds.
What are Debt Funds
Debt funds represent a category of mutual funds specialising in investments in bonds or debt instruments issued by various entities, including the government, banks, and corporations. These funds aim to provide investors with a steady income stream and preserve capital by lending money and earning interest. They serve as an attractive option for beginners seeking to invest in a low-risk and stable asset class that can potentially offer superior returns compared to fixed deposits or savings accounts.
Types of Debt Funds
These funds come in various types, differing in terms of bond maturity, credit quality, and sensitivity to interest rates. Here’s a breakdown of some common debt fund types:
- Liquid Funds: These invest in very short-term bonds with a maturity of up to 91 days, offering high liquidity and low risk. Ideal for short-term parking of surplus cash, they typically yield returns of around 3-5% per annum.
- Ultra Short Duration Funds: Investing in bonds with a maturity of 3 to 6 months, these funds provide slightly higher returns than liquid funds but carry a bit more risk. They can be used for short-term goals and may yield returns of around 5-7% per annum.
- Short Duration Funds: With a maturity range of 1 to 3 years, these funds offer moderate returns and risk. Suited for investors with a medium-term horizon of 2 to 3 years, they can potentially yield returns of around 6-9% per annum.
- Medium Duration Funds: Investing in bonds with a maturity of 3 to 4 years, these funds offer higher returns than short-duration funds but come with higher risk. Geared towards investors with a long-term horizon of 3 to 5 years, they may yield returns of around 7-10% per annum.
- Long Duration Funds: These funds invest in bonds with a maturity of more than 7 years, offering the highest returns but also carrying the highest risk. Suitable for investors with a very long-term horizon of more than 10 years, they can potentially yield returns of around 8-12% per annum.
Beyond these, there are specialised debt funds such as:
- Gilt Funds: These exclusively invest in government securities, considered the safest bonds. While they offer low credit risk, they come with high interest rate risk, and they may yield returns of around 7-9% per annum.
- Credit Risk Funds: These funds invest in bonds with lower credit ratings, offering higher interest rates but also higher default risk. Suited for investors with a high-risk appetite and a long-term horizon, they may yield returns of around 9-12% per annum.
- Dynamic Bond Funds: Providing flexibility to adapt to market interest rate movements, these funds offer moderate returns and risk. Geared towards investors aiming to benefit from changing interest rate scenarios, they may yield returns of around 6-10% per annum.
Taxation of debt funds depends on the holding period. Gains from selling units within 3 years are treated as short-term capital gains, taxed as per the individual’s income tax slab. If sold after 3 years, gains are considered long-term and taxed at 20%, with indexation benefit available to adjust the cost of investment with inflation, reducing taxable gains.
Risks in Debt Funds
While debt funds provide a seemingly stable and uncomplicated investment option compared to their equity counterparts, they are not without their share of intricacies. Navigating the world of debt funds requires a comprehensive understanding of the risks involved.
Let’s explore some of the key risks associated with debt funds and strategies to manage them:
1. Credit Risk: This risk relates to the potential default or downgrade of the issuer of a debt security. When an issuer fails to meet interest or principal payments or undergoes a credit rating downgrade, it can lead to a decline in the value of the debt security and the associated debt fund.
Mitigation Strategy: Investors can mitigate credit risk by evaluating the credit quality and diversification of the debt fund’s portfolio. Avoiding funds heavily invested in low-rated or unrated securities is also advisable.
2. Interest Rate Risk: Fluctuations in market interest rates can significantly affect the value of debt securities and debt funds. Rising interest rates typically result in falling bond prices, and vice versa.
Mitigation Strategy: To manage interest rate risk, investors should consider the maturity and duration of the debt fund’s portfolio. Selecting funds that align with their investment horizon and interest rate expectations can provide a safeguard.
3. Inflation Risk: Inflation risk pertains to the erosion of the purchasing power of investments in debt securities and debt funds due to inflation. This phenomenon reduces the real return on investment as the interest income becomes less valuable concerning the goods and services it can purchase.
Mitigation Strategy: Investors should assess the inflation-adjusted return or real return offered by the debt fund and opt for funds that provide returns exceeding the prevailing inflation rate.
4. Reinvestment Risk: Reinvestment risk is associated with the challenge of reinvesting interest income or principal amounts from debt securities and debt funds at a similar or higher rate of return.
Mitigation Strategy: To mitigate reinvestment risk, investors should evaluate the reinvestment options and rates the debt fund offers. Opting for funds with a history of consistent and stable returns can prove beneficial.
Basket Bonds: A Novel Approach to Debt Fund Investment
Basket bonds emerge as a compelling innovation in the world of finance, presenting investors with a fresh perspective on debt fund investment. These financial derivatives revolve around an underlying asset basket, a diverse amalgamation of commodities, securities, or currencies. What sets basket bonds apart is their unique feature: holders possess the right to buy or sell the entire basket at a predetermined price within a specific timeframe, yet they are under no obligation to do so.
Basket bonds serve multiple purposes in the realm of finance:
- Diversification: By offering exposure to a range of assets, basket bonds empower investors to diversify their portfolios across various debt securities, issuers, sectors, and geographies. This diversification strategy serves as a protective shield, mitigating the impact of adverse events on individual debt securities or issuers.
- Liquidity: The pooling of underlying debt securities within basket bonds enhances their liquidity. Consequently, investors can conveniently trade basket bonds, eliminating the challenges associated with individual securities characterized by low trading volumes or high spreads.
- Returns: Basket bonds often yield higher returns compared to individual debt securities. Their performance mirrors the combined dynamics of the asset basket, with returns influenced by factors such as credit ratings, maturity, and prevailing interest rates.
However, it’s essential to acknowledge the nuances of basket bonds, including their costs and risks. The creation and maintenance of a Special Purpose Vehicle (SPV), fees paid to originators, costs associated with rating Asset-Backed Securities (ABS), and trading expenses result in higher costs compared to individual debt securities. Additionally, basket bonds inherit the risks embedded in their underlying debt securities, spanning credit, interest rate, inflation, reinvestment, and liquidity risks. The composition, correlation, and volatility of the assets within the basket further influence these risks.
Debt funds offer a unique avenue for investors to explore the world of fixed-income securities. They provide regular income, capital preservation, and lower volatility compared to equity funds. However, it’s essential for investors to recognize and understand the various risks that accompany debt funds, including credit risk, interest rate risk, inflation risk, and reinvestment risk. Choosing debt funds that align with individual risk tolerance and return expectations is crucial.
Furthermore, basket bonds introduce an innovative approach to debt fund investment, offering diversification, liquidity, and the potential for higher returns. However, investors should remain aware of the associated costs and risks inherent in basket bonds.
Debt funds can outperform fixed deposits (FDs) in terms of returns, liquidity, and tax efficiency. They may offer higher returns, increased liquidity, and a more tax-efficient structure, especially in a declining interest rate environment.
Investing in debt funds can benefit those with a low-risk tolerance, a short to medium-term investment horizon, and a need for regular income. However, investors should be aware of associated risks such as credit risk, interest rate risk, and liquidity risk.
The best type of debt fund depends on individual factors like risk profile, investment goals, and time horizon. For short-term goals, consider liquid or ultra-short-duration funds; for medium-term goals, explore short or medium-duration funds; and for long-term goals, long-duration or gilt funds may be suitable.
Debt funds are generally considered safer than equity funds due to lower volatility. However, they are not risk-free and can experience negative returns.
Risks of debt instruments, such as bonds, debentures, and commercial papers, mirror those of debt funds. They depend on factors like credit quality, maturity, and interest rate sensitivity. Common risks include credit risk, interest rate risk, and liquidity risk.
Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.