Best Debt Mutual Funds

Debt funds are a pool of bond assets that investors can invest in. Unlike in the case of equity funds where the investors are predominantly individual investors, the debt funds have a large chunk of institutional investors like banks, pension funds, NBFCs, corporates etc. Debt funds typically invest in a mix of debt instruments (also called fixed income instruments) such as treasury bills, government securities, corporate bonds, and institutional bonds, call money, CP, CD etc. Generally, all debt securities have a fixed maturity and also pay fixed assured returns to bond holders. Debt funds create a diversified pool of debt assets by investing across a wide class of debt instruments.

Like in the of equity funds, debt funds also announce daily net asset value (NAV). These are announced each day evening and the next day investments and redemptions happen at a price based on this NAV. Debt funds invest in debt instruments for two reasons. They invest for interest income, which is regularly paid out by the bond issuers. Secondly, debt funds also invest for capital appreciation in bonds. How do bonds appreciate? Bond prices are inversely related to the yields in the market. For example, when the interest rates go up (RBI raises repo rates) then the bond yields go up and the bond prices go down resulting in capital loss. When the interest rates go down (RBI cuts repo rates) then the bond yields go down and the bond prices go up resulting in capital appreciation. Debt funds offer a wide variety based on duration and risk profile and investors can choose what suits them best. Debt instruments (bonds) issued is assigned credit ratings. Normally, G-Secs and Treasury Bills of the government are “AAA” rated but corporate bonds will have lower ratings based on risk perception. Debt funds also constantly trade these bonds in the market.

Bond funds or debt funds can be classified based on their maturity and their risk profile. We can also have open ended funds that are available for entry and redemption at any point of time. Then we have closed end funds that are only open for a fixed period and then it is closed and listed on the stock exchange. Fixed Maturity Plans (FMPs) are a very popular form of closed ended bond funds. Let us now focus on some key types of open ended funds.

• At the shortest end of the duration spectrum, you have liquid funds or money market funds. Liquid funds invest in highly liquid money market instruments and offer easy liquidity. The period of investment ranges from 1 day to 91 days. It is a smart way to hold your short term surpluses and earns more than a savings bank account.
• Ultra Short Term Funds or UST funds are slightly higher on the duration scale compared to liquid funds. There are also popularly known as Liquid-Plus funds and invest in very short term debt securities with a small portion in longer term debt securities. UST funds have an outer limit of 365 days maturity for debt they invested in. UST funds offer slightly higher returns compared to liquid funds, if you have a 6-month perspective.
• Floating Rate Funds are a category of funds that invest in bonds that offer variable rate of interest linked to a market benchmark. The reset of interest will happen at regular intervals. These funds are very useful in to protect your capital in a rising interest rate scenario as fixed rate funds will lose value in such a scenario.
• Short and Medium Term Income Funds invest in debt instruments of maturity up to 3 years. These funds can benefit in rising interest scenario and also in a falling interest scenario due to their exposure to medium term debt. These funds are ideal for investors who have a time frame of up to 12 months.
• Income Funds invest in corporate bonds, government bonds and money market instruments. Due to exposure to corporate debt, they carry credit risk and hence need to be monitored regularly. Income funds work best when interest rates have peaked in the market and are expected to go down.
• Gilt Funds typically invest in government securities (sovereign debt) of medium and long term maturities issued by central and state governments. Remember, that some state government bonds do carry a higher level of risk. These funds are free of default risk generally but they are very vulnerable to changes in the interest rates.
• Dynamic Bond Funds are a classic example of a fund where the maturities are actively managed by the fund manager. For example, the dynamic bond fund manager will reduce exposure to gilt funds if rates are going to rise and increase exposure to floating rate of liquid funds. There is a dependency on the fund manager view.
• Corporate Bond Funds essentially invest in bonds and debentures of varying maturities issued by corporates and private institutions. These funds offer higher yields but also carry default risk, as we have seen in the case of bonds issued by IL&FS and Amtek Auto in the past. You need moderately high risk appetite for these funds.
• Monthly Income Plans (MIPs) are a class of debt funds which also have a small exposure into equity. This adds to the risk but also enhances returns due to equity exposure. MIP exposure must be for a longer period of time. For tax purposes

Debt funds can appeal to different classes of investors; both retail and institutional. Let us look at some of the classes of investors who should be investing in debt funds.

• Individual investors must invest in debt funds as part of their financial plan. The financial plan lays out goals in terms of their size and maturity and debt funds add stability and regular income to your financial plan.
• Investors looking to pay short term assured outflows over the next 2-3 years can also look at investing in debt funds. For example, if you need to pay home loan margin after 3 years or your daughter’s admission fees after 2 years then debt funds would be the best.
• For retired investors seeking regular income in a predictable manner, debt funds can be very useful. Normally, debt funds do not run the risk of volatility to the extent of equities and hence most retired pensioners must look at debt funds for regular income as returns are also higher than bank deposits.
• Corporates can park their temporary surpluses of the business in a debt fund instead of a bank. The debt funds pay a higher yield compared to the bank deposits and thus it puts idle money to much better use.
• High Net worth investors (HNIs) and trader can also look to invest in debt funds as a means of capitalizing on key macro shifts. For example, an aggressive investor can buy long duration gilt funds when rates are expected to go down in the market. Similarly, if the view is of a rise in interest rates, then traders can look to investing in floaters.
• Debt funds can be a good way of parking idle funds profitably, when you are waiting for good opportunities to invest in equities.

Here are some of the key benefits that you can get by putting money in debt funds.

• Debt funds are less exposed to market volatility. We have all the gyrations of the Sensex and Nifty and the returns on equity funds in the short to medium term. If you put money in debt funds, they will be relatively less volatile. While debt funds do carry risk, they tend to be less volatile in terms of value compared to equity funds.
• Debt Funds also give you the advantage of diversification which is instrumental in reducing the risk. That is done by spreading your money across a range of interest bearing instruments like Treasury Bills, Government Securities, Corporate Bonds, Money Market Instruments etc.
• Equity funds are great for generating wealth in the long run. But you also need stability and security in the short to medium term. That is where debt funds come in handy. Since Debt Mutual Funds predominantly invest in debt securities, it lends stability to your equity portfolio by reducing the concentration of risk in your overall portfolio.
• Debt funds are highly liquid as you can redeem them at any time; either offline or even online on the internet. Debt fund redemptions typically get credited to your bank account the next day so they are as good as near-money. As an investor in debt funds there are no restrictions on withdrawal. Even closed ended funds are listed.
• Debt funds are more tax efficient compared to bank FDs and corporate bonds. Dividends on debt funds are tax-free in the hands of the investor but are subject to Dividend Distribution Tax (DDT) of 29.12%. A more efficient way is to hold it for more than 3 year so that it becomes LTCG and is taxed at 20% with benefits of indexation.

There is a strong element of fund selection in debt funds too. Here are the critical factors that you need to consider when investing in debt funds.

• First ensure that the debt fund fits into your financial goal. If your goal is to generate wealth in the long term then debt funds are not the place to be in. Debt funds are for stability and regular flows in the short to medium-term.
• Invest in a specific debt based on the time horizon. If you have a very short term time horizon then liquid funds are the best but if you have a longer time horizon then income funds or gilt funds could serve your purpose.
• The specific debt fund will also depend on the quantum of risk that you are willing to take. For example, if you risk appetite is low then you must stick to government debt funds or highly rated debt funds only. You should go for credit opportunities funds and medium term debt funds if you are willing to take on higher risk.
• The market outlook matters a lot. If inflation is likely to risk, then bond yields could risk too and that means your long term bond funds will see capital erosion. When inflation goes down, the reverse order works and you get capital appreciation on long dated funds. Position yourself accordingly.
• Duration of the fund also matters, especially if you are matching your debt funds with payables arising after time. For example, if you have a committed outstanding in 5 years from now, then you need to select a debt fund with an average duration of 5 years so as to minimize your interest rate risk.
• Style, pedigree and performance of the fund also matter. When you want stable returns do not go for dynamic funds with asset allocation discretion. Fund houses with pedigree generally avoid risky debt instruments. Focus on the past performance and benchmark to an index. Give more importance to consistency than to the CAGR returns.