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.

Markets at New High!

In current week both Sensex and Nifty registered respective life highs. The newspapers projected this as a major historical event with photos of people distributing sweets while sitting in front of terminal. They also carried articles showing journey from 100 in 1979 to 39000 in April 2019. One is wondering why there is such Hype about price of something hitting a new high. If one assumes some growth rate for price of a particular thing, mathematically it is very logical that it will make a fresh life high every day. In fact, we have Liquid Funds whose NAV (that is price) makes life high every day but no one (including me) makes any buzz about it. I think there is more to read in the new high from equity markets as compared to Liquid funds.

Media is focused on Short term

The media weather print or electronic wants continuous flow of buzz and news. Most of the times the terms such as bull markets, Rally, gain, loss, selloff etc. are used loosely without context to the objectives of long term investors.

Media has vested interests in focusing on short term to ensure consumers remain adhered to its services.

For a long term investor what matters is business performance of investee companies which gets updated once based on the quarter end earnings release. Media can potentially create a news only for a day or two out of it.

Equity – a volatile asset class

Share prices and in turn Indices are volatile and more sentiment driven at least in the short term which is very different from Liquid funds. Volatile means prices move up or down from current levels that’s the reason why Equity Price movements get so much media attention. Liquid Fund prices almost always go up unidirectional hence it is not exciting enough to make a news.

Price as an indicator of sentiment?

Price has lead effect on the flows meaning when Equity prices start going up more fresh money gets attracted into the markets. This happens because investors are attracted to positive historical performance. Also most investors are Loss Averse. Imagine an investor who bought BSE Sensex at 38800 in August 2018 which turnout to be a top with the benefit of hindsight, has seen it going down to 33300 in October 2018.

At this time with notional loss of ~14% the regretful investor feels “I got stuck in this!” Come April 2019 the Sensex is close to 38800, investor’s buying level, and instinctively loss averse investor will exit here at no loss.

When price goes even higher that means the selling pressure from investors like in our example is over and there are no investors with a feeling of “I got stuck in this” and there will be potentially more investors who will be ready to invest fresh money as the historical performance has improved. This creates a typical positive feedback loop which drives positive sentiment. Hence after hitting new high and continuing to holding on to it builds foundation of positive sentiment. Positive sentiment, if backed by other fundamental factors such as earning growth and valuations can lead to sustainable up move.

What it means for long term investors

News about New High in Markets in the first place should not be looked at like red alert on standalone basis. One needs to look deeper into other aspects of breadth of the up move, valuations growth outlook. Long term investors benefit from mistakes of general investors who are driven by emotions of fear/ greed & biases like loss aversion through better understanding of fundamental factors and cyclicality in markets.