What is a Debt?

“Debt” is a simple term that can be understood as any form of a loan – a financial transaction wherein one party lends money to another party for the pre-decided interest and tenure.

Two easy examples for a debt instrument can be a loan (a home loan for example) and a deposit (fixed deposit of a bank).

In the case of a loan the bank lends a certain sum to the borrower and the borrower (person availing loan) agrees to pay the interest usually in the periodic form (EMI) until the amount is fully paid. In case of a deposit, the depositor lends the money to the bank for a specified duration (term of the deposit) and in turn, the bank promises to pay the interest to the depositor.

In this article, we will be discussing various aspects of debt as an asset class for investment and debt mutual funds and various aspects of investment in debt mutual funds.

A debt instrument has the following inherent characteristics –

1. Fixed tenure – each debt instrument comes with a fixed tenure known as term/maturity. Take an example of a fixed deposit with a maturity of 2 years promising an interest payment of 8% to the depositor – 2 years is the term of the deposit.

2. Fixed cash flow – debt instruments have a fixed cash flow (hence they fall into the fixed income category). In the above example if let’s assume that that investor has done a 2 year fixed deposit for the amount of 100 and the interest promised is 8% it would mean that the first year the investor would receive Rs 8 and second-year Rs 108 (Rs 8 of interest and 100 of the principal).

3. A fixed-rate of interest – the debt instrument suffers a fixed/promised rate of interest which is called the “coupon”. In the case of the above example 8% interest promised is the coupon.

Debt as an Investment Tool?

 Investment in India is still dominated by traditional investment options such as a fixed deposit.

There is little awareness amongst investors for other sources of investments.

Debt as an investment tool provides the right alternative to traditional investments such as fixed deposits but debt investment is not as simple as is the case with fixed deposits.

What is a Debt Mutual Fund?

We have discussed debt as a concept, now let us try to understand what exactly a debt mutual fund is and how it works.

Mutual funds can be understood as a pool of money where investors pool in their money to be invested and managed by a fund manager for a common objective. For example in the case of fixed deposits investors pool in their money with a common objective to yield a stable return which is managed by the bank (who eventually lends the same money as loans)

In the case of bonds or debt mutual funds, things are quite different and hence it is very important to understand the concepts of debt mutual funds and then look for the opportunities available and how the debt funds can be used as an investment tool for one’s advantage.    

Key concepts in Debt Funds – Coupon, Duration, YTM, Modified Duration, Average Maturity  

Coupon

Is understood as the interest rate that the issuer of the bond has agreed to pay to the bondholder.

The coupon is always paid on the face value of the bond, not the market value. For example, a 100 rupees bond with a coupon of 8% for 3 years will make 3 payments of rs 8 each for three years along with the payment of Rs 100 (principal) as well.

Yield

The yield of the bond also accounts for the movement of interest rates over the period.

Let’s understand this with an example.

 From the above example, we have understood the concept of coupons.

For the same 100 rupees bond for 3 years with a coupon of 8 let’s say that after one year the interest rates come down to 6%, now the demand of the 100 rupee bond (issued 1 year back) will be more than the current rates being offered is only 6% whereas if an investor holds this bond for remaining 2 years the investor gets 8% and for this the bond is traded in the secondary market at a premium (mark to market gain).

On the contrary, if the current interest rate is higher say 10% and one is looking to sell the 100 rupees 8% coupon 3-year bond in the market the demand will be less as the current market is already providing a rate of 10% hence the bond which was issued a year back at 8% coupon will be sold at a discount (mark to market loss).

YTM

Is Yield to maturity – a debt mutual fund is a combination of various debt papers/securities with different maturities. A YTM is the rate of return that an investor gets if he holds all the bonds until maturity. An assumption here is that all these bonds in the mutual funds will be the same which not the case is as the fund managers keep on buying/selling the bonds depending on the research and fund objective.

It gives a broader idea to investors about the expectation of returns for that particular fund.

Modified Duration

Depicts the sensitivity of the price of a bond toward the change in interest rate. Since bond prices and interest rates are inversely related modified duration helps in understanding the effect (the extent of it) of interest rate movement.

For example, if a 100 rupees bond with a coupon of 8% has a modified duration of 5 years it implies that the decrease in interest rate to the extent of .5% (50 basis points) will increase the price of the bond by 2.5% (5 years *.5%) and conversely an increase in interest rate to an extent of 1% will decrease the price of the bond by 5%(1% * 5years).

Average Maturity

Is the weighted average of maturities of the bonds/securities held in the mutual fund portfolio.

A higher average maturity means that the fund will be more sensitive towards the interest rate movements, it also implies that the fund has to be held till that time for the returns (coupon) to realize.

Are Debt Funds Risk-Free – NO

There have been instances in recent times as well wherein debt funds have given negative returns or even underperformed even with a fixed deposit and given negative yearly returns as well.

Types of Risks in Debt Fund?

There is a lot of misunderstanding among the investors regarding the safety of debt instruments as an investment opportunity and many consider it as safe as fixed deposits, if not more unaware of the risks in debt mutual funds.

Many intermediaries in the market promote debt funds in a similar way to investors.

In this article, we will try to understand the risks involved in the debt mutual funds and the various debt mutual funds instruments available and also understand the risk-reward ratio of these funds.

Is Debt mutual funds risk-free?

The answer to this is plain and simple – Even debt is risky and can give negative returns hence there are risks in debt bonds and mutual funds, but the degree of risk is lower as compared to Equity as an asset class.

When we talk about debt or debt mutual funds one has to understand the concept of debt.

What is a debt mutual fund?

When any company or any entity wants to borrow money from the market but doesn’t want to dilute its ownership (equity) it borrows money in the form of debt (bonds).

One simple example is bank Fixed Deposit – through a bank fixed deposit bank accepts the money from an investor (borrowed money) and promises to pay certain interest on that (interest on the borrowed money) and uses the money to lend it to other businesses.

Two important concepts

1. For a normal understanding, we can define an asset as anything that has a price. 

2. And any asset that can be bought or sold in the market can give a price gain or loss both.

For example – Car (it has a price, hence an asset) can be bought and sold (hence can give price gain/loss) – but it will give price loss (depreciating asset).

Some other examples of depreciating assets are electronic items, furniture, etc.

On the contrary property, gold, etc is appreciating assets in nature since their value can increase with time (though they show volatility in their price).

Applying the same logic we can infer that assets that cannot be traded (bought and sold in the secondary market) such as fixed deposit as it’s a financial asset (it has a price) and it’s a non-tradable instrument hence there is no risk.

A debt mutual fund is a collection of various debt bonds and debt securities that are aligned with the objective of the fund.

Risks in Debt Mutual Funds

Debt mutual funds have below mentioned risks –

1. Liquidity risk

The bonds/securities in the mutual funds should be liquid so that when an investor is willing to sell his units the bonds can be sold and the money is paid back. 

There are some debt mutual funds which are not that liquid in the secondary market hence getting the money back at the time of need can be very challenging.

 For example, Capital Protection Funds (debt-oriented hybrid funds with 80% exposure to debt and 20% into equity) come with a lock-in of fixed tenure, usually 3 years or more. 

Though these instruments can be traded in the secondary market the demand is very less and since there are almost negligible buyers hence these are highly illiquid.

2. Reinvestment Risk

Let us understand this with an example – During 2008 the interest rates on fixed deposits were higher (10.5% for 1000 days deposits and 9.25% for 8 to 10 years deposits).

If there was an investor who didn’t need the money for 10 years and has done the fixed deposit for a tenure of 10 years he would have got that yield even today (2018) when the interest rates have come down to a paltry 6.5%.

FD interest Rates
Short and Long Term deposit rates

Source – sbi.co.in (SBI fixed deposit interest rate)

But as an investor, we tend to do these deposits for 1 year on an auto-renewal mode and also due to lack of understanding or lack of right guidance we don’t have a viewpoint on an interest rate movement.

 So the fixed deposit which has recently matured (since it matures every year) is now facing a risk to be reinvested at a lesser prevailing interest rate – this risk is technically called reinvestment risk.

The same analogy can be drawn for debt mutual funds.

 For example, in the case of short duration funds (with a duration of 6 months to 1.5 years), the bonds held in the funds keep on maturing at these intervals and in the economy where the interest rate is declining the fund manager is facing the risk of reinvesting the maturity amount at a lower current prevalent rate.

3. Credit risk

These bonds which are constituents of debt mutual funds are rated for their quality as per SEBI guidelines by various rating agencies like CRISL, ICRA, CARE, etc, and depending upon the ratings are the safety of the bonds as well as yield. 

For example, an AAA+ (highest rated) bond is the safest bond with lesser chances of a default hence the lesser interest rate on offer whereas a BB- (lowest rated bond) has the highest chance of default hence it offers a higher yield( premium for its lower credit quality).

The kind of risk associated with the credit quality of a bond is not only associated with the default of the bond rather there is also a possibility of a downgrade or upgrade of the bond rating.

A fund manager buys a low-rated bond with the possibility of the bond being upgraded and hence providing upside to the investor whereas in case the bond is downgraded the investor faces the risk of yield for that bond going down due to the downgrade.

4. Interest rate risk

This is the most important type of risk.

 Interest rate risk measures the price movement of bonds concerning the change in interest rate. The price of the bond is inversely related to the change in interest rate. 

Change in the price of the bond =                                                   1

                                                                        Change in interest rate * modified duration of the bond

For a bond whose modified duration is 5 years a decrease of 0.5% in the interest rate will increase the price of the bond by 2.5% (5 *0.5%) and vice versa. Hence it is very important as an investor to be aware of these risks while investing in debt mutual funds.

Debt VS Fixed Deposit–Comparison

A common trend amongst investor is to look for debt funds as a replacement or alternatives to fixed deposit which in the recent past was being directed towards balanced funds and have come down after SEBI reclassification and recategorization of funds, mainly due to aggressive selling/pushing of the balanced funds as an alternative to fixed deposits.

As we have already discussed the risks in debt funds its quite evident that debt funds are not risk-free as against the common misconception that they are.

It has to be understood that debt funds are not the replacement of fixed deposits especially for those who are dependent on their deposits for regular income (interest payments regularly) though debt funds offer a decently regular income.

Debt funds should be a part of an investment portfolio as an asset allocation strategy or a part of a core or satellite portfolio as the needs are.

To completely switch from fixed deposit to debt mutual funds might not be the right approach.

One of the advantages of debt mutual funds is the post-tax return. If redeemed after 3 years it attracts LTCG which is 20% with indexation. It’s discussed later in the article.

Types of Debt Funds in India –

SEBI in its recent circular of Categorization and Rationalization of Mutual funds has classified Debt Mutual Funds in 16 categories –

Categorization of Debt MF
Categorization of Debt MF
Categorization of Debt MF
Categorization of Debt MF

 For a better understanding of the risks in mutual funds, an investor can refer to the categorization of debt funds.

For example, Long Duration Funds (S.No. 9 in the above table) invest in debt and money market instruments with a Macaulay duration of greater than seven years which means that the investor is exposed to the risk of fluctuation of returns of long duration.

An increase of 0.5 % in the yield will bring a decrease in the price of the bond by 3.5% (0.5 * 7) and hence a higher risk as compared to the fund with a lower duration.

The risks involved in these funds are shown in the figure below –

Degree of Risk in Debt MF
Risk in Debt MF

As one can easily see the degree of risk is lowest in the Liquid category of funds which are used for very short term parking of funds, emergency or contingency funds whereas a Gilt Fund with a 10year constant maturity or a Floater fund has a very high degree of risk.

10 year returns of Guilt Fund
Historic Return of Guilt Funds as of August 2018

The picture above clearly shows that the guilt funds have given a negative return over 1 year and even for 6 months.  Whereas the table below shows the returns in dynamic bond funds which are either flat or negative over 1 year time period.

Hence, a prudent investor is aware of the risks involved in Debt mutual funds and constructs the portfolio accordingly.

negative return in debt fund
A negative return in Dynamic Bond fund

Hybrid MF –

Often investors come across bankers/advisors pushing certain funds called hybrid funds as a less risky option and replacement for fixed deposits.

Hybrid MF is a combination of equity and debt, a conservative hybrid fund will have a higher exposure to debt securities (hence debt taxation) and an aggressive hybrid fund will have a higher exposure to equity funds (hence equity taxation).

An aggressive hybrid fund with higher exposure to equity (more than 65% equity allocation) offers a higher return possibility due to the higher risk being taken due to exposure to stocks and also offers a better post-tax return as compared to a fixed deposit.

A conservative hybrid fund looks to create an alpha (extra return over the benchmark) due to slight exposure to equity (approx 70-75% debt and 25-30% equity) and hence the investor is taking that extra risk of being exposed to equity.

One important point to note for asset allocation is that the investor is being exposed to a higher risk asset class (a combination of equity and debt) from a conservative asset class i.e. fixed deposit hence investors are exposed to high-risk asset class looking for extra returns.

There have been instances when investors were pushed to balanced funds as a category and it saw lots of inflow from the fixed deposit for higher returns and even people opted for dividends to save on tax but when markets corrected they eventually lost money out of their capital as well.

Taxation in Debt MF –

The very basic reason why a person looks to invest across various asset classes is to get better returns than traditional methods of investments and to have gained on the capital invested (called a capital gain).

But one thing that bothers an investor is the tax that is being applied to these investments. Investors are often worried and confused about the amount of tax they have to pay mainly because of a lack of knowledge and understanding of the taxation in the investments.

Taxation on mutual funds depends on four factors –

1. Type of investments – not all asset classes is treated similarly. Different asset classes attract different taxation. As a thumb rule debt mutual funds attract higher taxation as compared to equity mutual fund investments.

2. Holding period – two important concepts as far as holding period are concerned are Short term Capital Gain (STCG) and Long Term Capital Gain (LTCG)  which defines the gains on the capital gain made in the short term and long term of the investment holding period. The definition of STCG and LTCG is different for different asset classes, namely Equity and Debt.

3. Amount of Capital Gain – capital deployed is the amount that an individual has invested and the gains on the capital are the amount of capital gain. For example, if an investor has deployed 5,00,000.00 (invested amount) and the value after 2 years is 5,75,000.00 (current value of the investment) then the capital gain is 75,000.00 on the capital of 5,00,000.00

4. Tax Bracket –taxation is not the same for every individual. Depending upon which tax bracket an investor falls into he has to pay the tax accordingly. Investors in higher tax brackets have to pay a higher amount of tax and hence should invest prudently. An illustration of tax slabs for various age groups for individuals is shown below –

Income Tax slab

Understanding Short Term Capital Gain (STCG) and Long Term Capital Gain (LTCG) in Mutual Funds –

A debt mutual funds have investment into debt or fixed income securities such as Government securities, corporate bonds, treasury bills, money market instruments, and other securities.

Definition of the short and long term across equity and debt mutual funds depends on their holding periods. The table below clearly shows the different rates of taxes applicable depending upon the type of investments.

Taxation in MF
Mutual Fund Taxation

Any capital gain before 3 years is considered as Short Term Capital Gain(STCG) which is taxed as per the tax slab of the investor (marginal rate of interest) and after 3 years it is considered as Long Term Capital Gain (LTCG) and is taxed at 20% with indexation.

What Is Indexation?

In simple terms, indexation is taking into account inflation.

Let us understand inflation with an example. You have won a lottery of 1 lakh and have two options; either take the entire prize money today or after 1 year. It is a no-brainer that you will take the prize money today.

Why would you do so?

Because the value of 1 lakh today is higher than the value of 1 lakh after 1 year.

Inflation is the real culprit here.

The purchasing power of money decreases over a period of time due to inflation. The value of 1 lakh 20 years ago was much higher; you could end up buying a car with that money but not today.

Similarly, when you invest the returns that you have generated are after the inflation so if any investor has made 12% returns on his investments and inflation is 6 %, his net returns (inflation-adjusted return) are only 6%.

LTCG in debt funds takes the same things into account.

In a very simple language, one can understand that in Debt mutual funds, the capital gain after 3 years (LTCG) is calculated after deducting the returns accounted for due to inflation hence the only net returns are taxable.

LTCG in Debt MF
Indexation benefit in Debt MF

The table above shows the taxation in debt mutual funds as well as the indexation benefit. At the marginal rate of 30%, the investor has to pay a tax of 8,700.00 (which an investor would assume) but after 3 years, it classifies as LTCG hence indexation comes into the picture.

After Indexation (color-coded yellow) shows the calculation once indexation is applied.

Cost Inflation Index (CII) is the inflation-adjusted purchasing price that is calculated to compute capital gains.

In the example above the actual amount invested was 1,00,000.00 but due to inflation the value of 1,00,000.00 invested 3 years back is now 1,29,000.00 (calculated by CII).

Inflation-adjusted cost price = CII for the year of sale/CII for the year of purchase)* Cost of Purchase

How is a Dividend taxed?

Not only capital gains but dividends in mutual funds are also taxed.

Earlier the dividends from equity mutual funds were tax-free but with recent changes in taxation dividends from both Debt and Equity Mutual Funds are taxed.

Dividends from debt mutual funds are taxed at 25% (28.28%) with a surcharge. The dividend is paid by the AMC and the amount at the investor’s hand is tax-free.

Side Pocketing in Debt MF –

Side pocketing could be understood as having two different pockets; one pocket has good assets (bonds with good credit quality) and the other pocket holding bad assets (bonds with not so good credit quality papers/securities).

This strategy helps in keeping the NAV (Net Asset Value) stable and protects retail investors in case there is a sudden downfall and sees an outflow of FII or Institutional investors the funds with side pocketing will impact only the pockets having bad assets and shield retail investors.

In this case, two schemes are created one with good (liquid papers and another with bad (illiquid) papers.

Let’s understand this with a simple example. Assume there is a fund with 100cr AUM (asset under management) and holds a bond of ABC company worth 10cr (10% weightage). Now if this paper defaults and investors, mainly institutional investors tend to redeem money and in such a situation, the fund manager has to sell the liquid (good) securities to make the payment, and hence retail investors have to bear the loss as well and they still bear the bad papers in the fund as those papers have become illiquid.

And it will increase the overall percentage of the bad asset (which earlier was 10% now might become 20%) in the mutual fund. in case if side pocketing is done the good papers remain unaffected and when the bad papers will pay the money the investors will get their money back.

How to Choose a Debt Fund –

We have listed down few steps which can be used as the process for selection to make things simpler for investors –

1. Analyze your risk-taking ability

Now we have an idea about the risks involved in debt mutual funds and one has to understand their risk-taking ability. Understanding risk is one thing but facing it at different times is completely another. Investors get rattled once they see negative returns in their portfolios hence it’s important to align one’s investments with one risk-taking ability.

2. Carefully note down the investment time horizon

Debt mutual funds offer a wide range of products ranging from very short term (1 week) to long term (10years) investment time horizon. As investors, it’s very important to understand and note down one’s investment time horizon.

3. Align time horizon with funds maturity

This involves looking for products that are rightly aligned with one’s investment horizon and maturity (average maturity) of the mutual funds. This is an important aspect of mutual fund investment in debt.

The risk the client faces if they have a short term horizon (let’s say 3 months and they are investing in a fund with a long maturity (let’s assume 5 years) this means that the investor’s money is exposed to the risk/uncertainty of 5 years even though his horizon is only 6months.

On the other side of the ones, the investment horizon is 5 years and invested in a fund of maturity of 6 months (liquid or ultra short term) then the investor faces a reinvestment risk as discussed above.

4. Select the right product

Once the above three steps are done with then the investor has to select the right fund and fund house. For example, if an investor has a horizon of 5 years and has chosen a fund with let’s say an average maturity of 5.2 years or 5.5 years (in the alignment of investment horizon) even then different funds might have different risks. One fund might hold lower-rated bonds another might hold high-rated bonds hence the credit risk is different in these two funds.

5. Review the funds

As an investor keeping an eye on the performance of these selected funds is also very important. For example, after the recent default of IL&FS certain funds of DSP and HDFC fund houses suffered more fall in their NAV as compared to their peers due to higher exposure to these bonds. Another example is that of DHFL default where few funds saw a single day dip in NAV seen to an extent of 50% (yes! Single day fall of 50% in NAV in a debt fund).

As we have seen debt funds offer multiple avenues of investments with varied risks ranging from safer options compared to that of fixed deposits to that of much higher risky options. Our advice for investors is to be aware of the risks that they are taking and the risk-adjusted return that the specific fund is offering.