Primer on Debt Funds

What are Debt Funds?

  • Debt funds are those funds which invest predominantly in various types of debt and money market securities like treasury bills, government securities, corporate bonds, commercial paper and certificate deposit.
  •  In general the debt securities have a fixed maturity date and pay a fixed rate of interest. The returns of debt mutual funds come from two avenues viz. interest income and capital appreciation/depreciation based on market value of the securities.
  • Every debt security is assigned a credit rating helping us to assess the capacity of issuer to repay the debt/loan.

Why Debt mutual funds

  • Debt funds offer investors to participate in debt markets of India with small ticket size. Variety of debt funds running different strategies are available.
  • By investing one debt scheme one holds ~30-40 different securities issued by different issuers like Government of India, State Government, Big Corporate and Banks. The choice of securities is made by professional Fund Managers having vast experience in the field of credit analysis, fixed income security analysis.
  • Usually the returns are not impacted by volatility in equity markets. Thus due to less volatility, debt mutual funds should bring stability to overall portfolio returns.
  • Liquidity need can be met through open-ended structures, although exit loads may be applicable in some cases.

Different types of Debt Funds

There is a wide range of debt mutual funds; suitable to invest depending upon investment horizon and capacity to take risk.

Other than the ones mentioned above there are close-ended debt funds. These include Fixed Income Plans (FMPs) having fixed tenure and interest rate.

Capital protection funds and multiple yield funds also form part of Debt mutual offerings.

Factors affecting returns

Some of the factors which may influence the performance of debt funds are listed below

  • Interest rate scenario-Domestic & Global markets
  • Inflation
  • Liquidity in money market
  • Monetary Policy stance/ Regulations by the RBI, Government of India
  • Growth in economy and overall macro-economic situation

Risks in Debt Mutual Funds

  • Credit risk – Impact due to credit migration or default risk
  • Interest rate risk – Impact on price of a bond due to changes in interest rate changes.
  • Liquidity risk – Inability of the fund to sell its investments and meet redemptions of investors due to poor market conditions 
  • Re-investment risk – Inability to reinvest cash flows (e.g., coupon payments) at a rate comparable to the current investment’s rate of return.

Life Stages & Investing

At different stages in life, the objectives and needs are different.

During one’s earning life, money is saved from the current income to take care of the future. This is the Accumulation Phase.

The investment objectives in the 4 stages in Accumulation Phase are:

  1. Single, starting employment
    • Starting a saving habit
    • Emergency fund equal to at least 6 month’s expenses through bank deposits
    • Small beginning of equity investments through SIP
    • Start PPF, NPS accounts
    • Setting aside “margin money” for housing loan
    • Getting adequate term insurance & accident insurance
  2. Marriage
    • Monthly and annual budget of income, savings and expenses
    • Buying a house and getting a housing loan
    • Monthly instalments of housing loan build your house ownership
    • Family floater health insurance
    • Increasing equity fund SIPs
  3. Starting a Family
    • Changes in monthly budget
    • Buying a car and getting auto loan
    • Education funding for children – short term through debt funds, long term through equity SIPs
  4. Approaching Retirement
    • Children education goals nearing completion, responsibilities reduce
    • Income increases as career advances
    • Housing loan EMIs as percentage of income come down
    • Increase equity investments through SIPs and stock portfolio
    • Term insurance needs come down
    • Joint names and nomination in investments

After achieving financial stability, one has earned the “freedom to retire”. The income and cash flows from the accumulated wealth enable living with self-respect and comfort. The 5th & 6th stages in the life cycle fall in this Distribution Phase. The investments considerations are:

5.Retirement

  • Cash flows from existing investments used for expenses – systematic withdrawal plan
  • Golden period in life – when time, money & energy are all present
  • Discretionary expenses – such as travel – need to be budgeted
  • Portfolio partly shifts to fixed income investments, but equity still continues
    • Provision for health care expenses – top up on health insurance 

6.Succession & Estate Planning

  • Creating a will
  • Financial security for single spouse
  • Careful distribution after your life to next generation