A spate of recent payment defaults and bankruptcies have taken its toll. The average mutual fund investor’s confidence when it comes to investing in debt instruments is crippled. In this post, we examine the different types of debt instruments and what works best in what situations. We also understand the risk in debt instruments, taxation and some debt mutual funds you can invest in.
What is covered in this article?
What are Debt Mutual Funds?
Debt mutual funds are those that invest in fixed income instruments like government bonds, corporate bonds, debentures, money market instruments etc.
The primary objective of debt mutual funds is to protect your capital. The secondary objective is to give investors adequate appreciation in capital.
Debt instruments are ideal for risk-averse investors who aim for regular income. They are also preferred by corporates, insurance and pension companies for their low cost structure, high liquidity, reasonable safety and stable returns.
The Indian mutual fund industry has seen excellent offtake of debt funds with the AUM crossing well over ₹13,00,000 crores
Advantages of Investing in Debt Mutual Funds
Debt mutual funds offer many advantages which include –
- Meeting short-term goals. This can be goals like paying a child’s school fees or having an emergency fund or a goal ranging from 1 month to 3 years
- Liquidity. Debt funds allow investors to withdraw or redeem from their corpus with no lock-in.
- Tax benefits. Indexation benefits are available on long term capital gain when investors stay invested for over 3 years
- Regular Income. Income on a monthly or quarterly withdrawal plan basis is available in a tax efficient manner with Systematic Withdrawal Plans
- Diversification of portfolio by reducing volatility and offering stable returns
- Potential to earn higher returns as compared to traditional options like a savings bank account
What is the difference between Debt Mutual Funds and Fixed Deposits?
Real estate and fixed deposits at banks have long been the default mode of investing. These have been the ‘safe’ instruments for the risk-averse Indian investor.
But in the last few years, debt mutual funds have offered a promising alternative instrument of choice. The growing masses of millennial investors have lapped these as they offers greater choice, flexibility, liquidity and returns.
Debt mutual funds and fixed deposits have many points of comparison as examined in the table below.
Are Debt Funds Risk Free?
No. Debt funds are not risk-free.
The de facto risk-free fixed income instrument is the bonds issued by the central government. But even these are not 100% safe as we have seen in countries such as Argentina, Greece, Iceland, Russia and Mexico.
Assuming we aren’t going to see a default of this nature, we can assume that the Government of India bonds are super-safe or risk-free for all practical purposes. Perhaps this is why you see the lowest interest rate on these papers.
Investors do factor some risk and volatility in debt mutual funds but almost never in liquid funds, low duration and ultra short term funds.
All other debt funds are above the risk grade of the government of India bonds. We shall be discussing these in greater details in the coming sections.
Risk & Return – The Yin and Yang of Debt Funds
Types of Risks in Debt Funds
Risk in debt funds come from two primary concerns –
- The risk of default in interest payment and/or principal
- The risk of changes in interest rate
Risk of default
Risk of default in interest payment and/or principal talks about the safety of capital.
Let’s understand this with the example of a bond of a single company.
When you purchase a bond from a company, you are effectively loaning money to this company. Against your loan, the company promises to pay you interest (or coupon) at regular intervals in addition to paying back the principal.
Now if the underlying security (i.e. company) were unable to have enough liquidity or cash in its books to pay off your interest or principal – a credit default gets triggered. This event can lead to investors losing their entire principal or some part of it.
We’ll look at DHFL NCDs now as an example.
The image below shows the price of DHFL NCD (non convertible debentures) prices on 9 June 2019. All these bonds were issued at ₹1,000 but are languishing at a discount of 25-55%. This price drop was due to DHFL missing out on some bond payments. This act put a massive question on its ability to service the debt obligations that it had on its books. In other words there was a high credit default risk on this instrument.
Risk of changes in Interest Rate
It’s quite simple. When there is a hike in interest rates, it makes the existing bonds which were offering lower interest rates less desirable. This lowers the demand for these bonds thereby reducing the price of these existing bonds.
Related Information: How to calculate bond prices
Can Debt Funds give Negative Returns?
Yes, debt mutual funds can give negative returns.
This happens when the scheme has been hit with a default risk or an interest rate change risk. Like any market, there is speculation. So the perception that a default or interest rate change is bound to happen is enough to change bond pricing. This can lead to negative returns in tradeable instruments like mutual funds, bonds, debentures etc.
Let’s examine this with a couple of examples
Example of Default Risk
UTI Credit Risk Fund has over ₹1,400 crores in AUM. The fund has done rather well over the last few years with returns of 7.70% in 2013 and 11.46% in 2014. In other years, it continued good performance with 8.86% in 2015, 10.30% in 2016, 6.90% in 2017 and 5.45% in 2018.
2019 and onwards has been a horrible period for the UTI Credit Risk Fund. The fund had to markdown in the months of Jun 2019, Sep 2019 and Jan 2020 due to exposures on –
Net net, the UTI Credit Risk Fund is down by 14.62% over the last one year. This is one of the biggest drops in debt funds I have seen in the last 5 years.
Example of Interest Rate Risk
HDFC Gilt Fund is a ₹1,200 crores sized fund. The objective of the fund is generating reasonable returns by investing in government securities (or guaranteed by government securities) with medium to long term maturities. This means taking a view on the bonds whose maturity is anywhere from 3 to 10 years away. This is called duration risk which makes the fund subject to swings in prices as seen in the chart below.
The HDFC Gilt Fund has delivered negative returns in three of the last 12 quarters. There were returns of -0.90% in the Jan-Mar 2017 quarter, -1.55% in the Oct-Dec 2017 quarter and -0.81% in the Apr-Jun 2018 quarter.
To put that into perspective, if a user had invested money in this fund on 05-Jan-2017 and checked the portfolio performance almost an year later (on 28-Dec-2017), the investor would have made negative returns.
Having said this, certain debt mutual funds are less risky while some carry a much higher risk element to them.
How Debt Funds offer Returns?
Debt funds primarily follow two strategies to deliver returns to investors –
- Accrual strategy
- Duration or Capital appreciation strategy
An accrual strategy of earning returns on debt funds is primarily dependent on interest income. The aim of the fund manager is to generate returns by earning higher yield. This requires managing the credit risk while minimizing interest rate risk.
This strategy is generally followed by shorter maturity funds like liquid funds, ultra-short term funds, short-term debt funds and income funds. These funds typically hold the papers until maturity and reinvest the proceeds into fresh issues.
A duration strategy is focused more on capital appreciation. This capital appreciation happens when bond prices rise due to a fall in interest rates. This strategy does not give much credence to interest income which is the mainstay of the accrual strategy.
The fund manager aims to generate returns by actively managing interest rate risk by investing in long term debt instruments like gilt funds.
Accrual and duration strategies in debt funds relate to different investor goals.
- If you are looking at regular income, then you are better off with an accrual strategy.
- However if you are a first time investor, it is better for you to lean on duration strategy funds. Accrual funds carry a bigger risk as defaults or rating downgrades can devastate a fund’s NAV. We saw the case of UTI Credit Risk Fund earlier in this post.
What are the Different Types of Debt Mutual Funds?
The different types of debt mutual funds from which investors can choose from are –
- Overnight funds
- Liquid funds
- Ultra Short Duration funds
- Low Duration funds
- Money Market funds
- Short Duration funds
- Medium Duration funds
- Medium to Long Duration funds
- Gilt funds
- Long Duration funds
Debt mutual funds are classified on the basis of their indicative investment horizon and their investment strategy.
Investors can choose a debt fund based on the time horizon, liquidity needs and their risk appetite.
Let’s understand each of these debt funds as described in the table below
Some Useful Tips on How to Choose Your Suitable Debt Fund
- Make capital protection your primary object when investing in debt funds. New investors often chase returns in debt funds. They have this flawed assumption that debt funds are a source of making plentiful wealth. This is not the case. With every investment in debt fund make sure you ask yourself the question – “Will I lose money?”
- Your needs should match the duration of the fund. Don’t buy a long-term fund like a gilt fund if your investment horizon is only 3 months. You will be better served with a liquid fund or ultra short duration funds. Refer to the investment horizon column in the table above to choose the right type of fund
- Set your risk and return expectations before investing. While credit risk funds that invest in low rated securities offer potentially higher returns, they come with commensurate risk. This risk is in the form of a credit downgrade or default. If you don’t have a high risk appetite, then opt for funds that invest in AAA securities only. These AAA heavy funds will offer you better risk but at a mildly lower return
- Diversify well. It makes good sense to choose funds across complementary debt fund buckets. Assess accrual strategy v duration strategy, money market v gilt funds etc. when identifying debt mutual funds. And only after a clear assessment of your needs and risk-return expectations. It is well-known that the highest risk-adjusted returns go to a well-diversified portfolio across assets rather than choosing a particular fund
Performance of Debt Funds
It has truly been a tale of two cities.
Credit funds have seen a lot of stress in the debt mutual fund category and have performed negatively over the last one year. The average credit risk fund has yielded -0.23% returns over the last one year.
On the other hand, long duration debt funds and Gilts with 10 year Constant Duration have performed exceedingly well. Infact, at the time of writing this article, no equity fund has been able to top the returns of these two category of debt funds.
I have compiled a list of trailing returns of debt funds over 1 year, 3 years, 5 years and 10 years in the table below. This data is updated as on 19th Jan 2020.
Best Debt Mutual Funds for 2020
Best Overnight Funds for 2020
The Best Overnight Funds for 2020 are –
All the above funds have an AUM of atleast ₹2,000 crores. Additionally, the fund managers have been managing these overnight funds for over 6 years now.
Best Liquid Funds for 2020
The Best Liquid Funds for 2020 are –
Liquid funds are fashioned to not take unnecessary credit risk to improve returns. Capital protection is the primary objective here but yet, in a bid to chase higher returns, some liquid funds invest in low-rated instruments that promise higher yields.
To avoid these scenarios, SEBI has changed the valuation norms of liquid funds since mid-2019. Per the new rules, funds have to mark-to-market. This means the value of the fund should be on the existing market prices for all maturities which are over 30 days. This mark-to-market rule was earlier for over 60 days maturities. As a result, fund managers have started to favour 30-day maturities which lowers the potential gains due to the shorter maturity.
Best Ultra Short Duration Funds for 2020
The Best Ultra Short Duration Funds for 2020 are –
Ultra Short Duration debt funds are a popular category with millenials investors. The category AUM has crossed ₹1,00,000 crores. These funds invest in bonds maturing in 3 to 6 months and aim to earn slightly better returns when compared to a bank fixed deposit. This makes them an attractive investment instrument.
While the risk of incurring a loss is quite low, but low does not mean never. Infact, as recent as 16 January 2020, we saw a serious drop in NAV of one of the more popular picks in this category. The NAV of Franklin India Ultra Short Duration Fund dropped by 4.3% in a single day. This wiped out its gains over the last six months. This happened due to the default risk emerging from the 8.25% Vodafone Idea 2020 paper they held. This was a BBB- rated instrument which had higher risk but offered better yields.
Best Low Duration Funds for 2020
The Best Low Duration Funds for 2020 are –
Recently, the Franklin India Low Duration Fund has seen a drop in NAV for two months in a row. This was due to default risks from Essel Infraprojects in December 2019 and then with Vodafone Idea in January 2019. Since 3-Dec-2019 until now, the fund has lost 7.7% in value.
It’s important to know the difference between Franklin India Low Duration Fund and the ones from Kotak, Aditya Birla and HDFC. The Franklin India fund has had a penchant to take higher risk and invest in AA or even lower papers. The Essel Infraprojects and Vodafone Idea bonds were rated BBB- by rating agencies but the fund from Franklin India held them as they offered higher yields. When choosing a low duration fund, it is better to check the portfolio. If you are a risk averse investor, opt for funds which have more AAA and A1+ rated papers
Best Money Market Funds for 2020
The Best Money Market Funds for 2020 are –
Money Market funds invest in bonds with a maturity of upto one year. These happen to be one of my favourite debt instruments if chosen with care. They generally offer returns in the 7.5-8.5% range with a high level of predictability especially if investments are made in funds which employed high rated securities in their portfolio.
Best Dynamic Bond Funds for 2020
The Best Dynamic Bond Funds for 2020 are –
Dynamic Bond funds have the flexibility to invest in bonds of any duration. It is advised that these bonds are held for a period of atleast 3 years. But a word of caution – dynamic bond funds come with their fair share of risk. There are credit calls, liquidity calls and interest rate calls that the fund manager has to assess. The UTI Dynamic Bond Fund have had many troubles over the last one year with a negative performance of 2.6%.
Taxation Structure on Debt Funds
Any kind of capital gains made on debt mutual funds is taxable.
If you were to redeem a debt mutual fund before 36 months of its purchase, then tax will be charged on the capital gains at your prevailing income tax slab. This is called short term capital gain
However, if you were to redeem after 36 months of purchase, then tax will apply on the capital gain at 20% with the benefit of indexation. This is long term capital gain
Let’s understand this better with an example.
Short term capital gain in debt funds
You purchased ₹1,000 worth of units in a debt fund on 01-Jan-2015. And sold all these units on 30-Sep-2016 at a price of ₹1,200.
Since the sale was effected within 36 months, short term capital gain shall apply which shall be at your current income tax slab of say, 30%
- Sale price = ₹1,200
- Purchase price = ₹1,000
- Short term capital gain = ₹1,200 – ₹1,000 = ₹200
- Tax slab applicable = 30%
- Tax to be paid = ₹200 * 30% = ₹60
Long term capital gain in debt funds
In this scenario, you purchased ₹1,000 worth of units in a debt fund on 01-Jan-2015. And sold all these units on 15-Feb-2018 at a price of ₹1,600. Since the sale was effected post 36 months, long term capital gain shall apply.
It is important to know the cost inflation index for the financial year when the units were bought and when the units were sold. I have attached the latest cost inflation index below in the article.
The cost inflation index for FY2014-15 (applicable on the purchase of 01-Jan-2015) was 240 and that of FY2017-18 (applicable on the sale of 15-Feb-2018) was 272.
- Sale price = ₹1,600
- Purchase price = ₹1,000
- Indexed purchase price = ₹1,000 * (272 / 240) = ₹1,133
- Long term capital gain = ₹1,600 – ₹1,133 = ₹467
- Tax slab applicable = 20%
- Tax to be paid = ₹467 * 20% = ₹93.4
Read: Latest tax rates on mutual funds as per Finance Bill 2020
How to save taxes on debt funds?
A very useful tip which I always use.
I would have ideally postponed my sale of the debt fund units by another 45 days into April 2018. This would have pushed my sale into FY2018-19 which would have added an additional year into my cost inflation index calculation. This move would help me lower my taxes even further.
Let’s understand this extending our previous illustration assuming that the sale price on 2-Apr-2018 is still at ₹1,600. The cost inflation index for FY2018-19 is 280.
- Sale price = ₹1,600
- Purchase price = ₹1,000
- Indexed purchase price = ₹1,000 * (280 / 240) = ₹1,166
- Long term capital gain = ₹1,600 – ₹1,166 = ₹433
- Tax slab applicable = 20%
- Tax to be paid = ₹433 * 20% = ₹86.6
This is one reason why we see a decent spike in purchase of debt funds in the month of March each year and selling of debt funds in the month of April.
Cost Inflation Index Table for Calculating Indexation
The table below shows the cost inflation index table from the year 2001-02 to 2019-20
The cost inflation index table is available on the Income Tax India website.
- The debt mutual fund market is as big as the equity mutual fund market in India
- Debt funds are not risk-free. Some category of debt funds carry considerable amount of risk as shown in many examples over the post
- Two key risks that a debt mutual fund is exposed to are interest rate risk and credit risk
- A debt mutual fund earns returns using an accrual and/or duration strategy
- Indexation benefits can be used to reduce the tax to be paid on capital gains
Additional Resources You Might Like
Here are some articles you might like:
- Rakesh Jhunjhunwala and his secrets to investing (Part 1)
- Building a high return portfolio with index funds – a step-by-step approach
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- The trillion dollar index fund story that John Bogle started in the 1970s
- Best SIP for achieving long term goals