Decoding debt funds for the investor.

The last financial year was an unusual year for the Indian economy as corporate earnings fell, investments plunged, current account deficit widened and the GDP growth rate fell to a near decade low. Coupled with that concerns regarding inflation, currency movements and dismal government finances and uncertainty on the global front meant a poor show by the Indian economy.

Given that interest rates have declined by 100 basis points over the past year and may remain at the current levels, bond schemes may do well. Which bond schemes are worth buying now? Bond schemes are for investors seeking returns slightly higher than from other safe avenues like fixed deposits.

When interest rates are on a rise bond prices go down and when interest rates are falling bond prices go up. But if there is no change in interest rates bonds will deliver the current rate of yield or interest rates. More or less we are in the third scenario and this is a good time to invest in bonds. For this first let us understand the basics of debt funds.

Debt mutual funds generate returns for their investors’ by investing in bonds or deposits of various kinds. They basically lend money and earn interest on the money they have lent. This interest that they earn forms the basis for the returns that they generate for investors.

Even individual investors do something similar when they do something as simple as make a fixed deposit in a bank. When you make an FD with a bank, you are basically lending money to the bank. A simple way of understanding debt funds is to think of them simply as a way of passing through the interest income that they receive from the bonds they invest in.

Unlike the FDs that individuals invest in, mutual funds invest in bonds that are tradable, just like shares. The way there’s a stock market where shares are traded, there’s also a debt market where bonds of various types are traded. In this debt market, the prices of different bonds can rise or fall, just like they do on the stock markets. If a mutual fund buys a bond and its price subsequently rises, then it can make additional money over and above what it would have made out of the interest income alone. This would result in higher return for investors.

But why do bond prices go up and down ? The major reason is a change in interest rates, or even the expectation of such a change. Suppose there’s a bond that pays out interest at a rate of 9 per cent a year. Then, the interest rates in the economy fall and newer bonds start getting issued at 8 per cent. Obviously, the old bond should now be worth more than earlier. After all, a given amount of money invested in it can earn more money. Its price would now rise. Mutual funds that hold it would find their holdings worth more and they could make additional profits by selling this bond. Again, obviously, the reverse could happen when interest rates rise. The fluctuating prices of bonds can be used to enhance your portfolio’s returns by investing in debt funds.

Debt Fund Vs Fixed Deposit a comparison

Features Debt Fund Fixed Deposit/Bank Deposits How debt fund score over FD
Flexibility Any amount of money, can be invested any time in the same/existing debt fund. Similarly any amount of money or partial money can be withdrawn anytime. Any amount of money cannot be invested into existing fixed deposit. For any new money to be invested, a new fixed deposit needs to be opened. Debt fund provides better flexibility to manage, invest or withdraw, investment.
Earn interest for every day of investment Debt fund provides return for each and every day of investment. Fixed deposit for certain periods, like days after maturity, may or may not provide return. In debt fund return is not lost even for a single day.
Principal Guaranteed Historically certain debt funds have never lost / reduced the investment principal Yes Principal of a debt fund can see erosion if the interest rates go up.
Return Guaranteed No, but historically certain debt funds have never given negative return Yes Return from debt fund is positive and comparable to fixed deposit

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Traditionally fixed deposit is the safe and guaranteed return investment product. But except for the comfort of guaranteed return in fixed deposit, debt fund is a far superior investment for all age group of investors.
Debt funds have an advantage in terms of liquidity as well as superiority of returns. However, now an individual will have to look at the investment based on the matrix given below:

 

 

Investment Matrix

Taxable Income REQUIRE Regular Income DO NOT REQUIRE Regular Income
Tenure of Holding
Long Term Short Term Long Term Short Term
(more than 1 year) 06 M 612 M (more than 1 year) 06 M 612 M
Less than Rs. 11 lacs Fixed Deposits Debt Funds Debt Funds
Between Rs. 11 25 lacs Debt Funds or Fixed Deposits
More than Rs. 25 lacs Debt Funds Debt Funds Dividend Reinvest

 

 

 

 

 

 

 

 

 

 

A fall in rates going forward will be good for long-term gilt and income funds. Actively-managed income and gilt funds work well for those with an investment horizon of more than a year. Those with a horizon of up to six months should invest in ultra short-term funds whose average maturity period is three-six months. Due to their short duration, these funds carry a low interest-rate risk. Those looking at a slightly longer period of up to one year can put money in short-term funds which invest in corporate bonds. Most such funds have maturity of two-three years.

Long duration gilt and income funds have returned more than 10 per cent in the last one year. Short-term funds, too, are not behind.

Debt investors may be spoilt for choice for the remaining part of the year. With all likelihood of interest rates either remaining at current levels or moving downwards, debt mutual funds are expected to give handsome returns if past instances are anything to go by.

~  Juzer Gabajiwala.

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Mr. Juzer Gabajiwala is a Chartered Accountant & Company Secretary by qualification and has over 20 years in the field of investments and finance. Mr. Juzer Gabajiwala joined Ventura Securities Limited (VSL) in December 2005 as Head – Mutual Fund Products Distribution and elevated to the post of Whole Time Director since June 2008. He has set up the entire distribution network for PAN India operations and is responsible for alternate products investment advisory services including Wealth Management and NRI services. He has been associated with Larsen & Toubro Limited; Telco Dealers Leasing & Finance Limited, IIT Capital Services Limited and Premchand Group in various capacities of his career spanning 20 plus years.