A Guide to Debt Funds – All About Debt Funds
There is a popular saying in Wall Street that “Gentlemen and governments prefer bonds”. Referred to by various names like bonds, debt and fixed income instruments, they essentially mean the same thing. Unlike an equity, which is an instrument of ownership of a company, debt creates a relationship of lender and borrower between two parties. The borrower raises money by issuing bonds while the investor looks to earn assured fixed income by investing in such bonds.
What are some of the benefits of investing in debt funds?
Depending on your financial goals, fixed income investments have a number of distinct advantages for the investor.
- First and foremost, these debt funds offer diversification from stock market risk. Generally, debt funds are said to carry lower risk than stocks. This is because fixed income assets are generally less sensitive to macro risks like economic downturns, sectoral downturns and geopolitical events. When stocks go into a downtrend, these debt fund investments will help to offset some of the equity loses.
- Secondly, debt funds are the best cut out for capital preservation. What does that mean? Capital preservation means protecting the absolute value of your investment via assets that have a stated objective of return of principal. Since, fixed income typically carries less risk, these assets can be a good choice for investors who do not have too much time in their favour to recoup losses.
- They also provide the all-important regular income generation. Fixed income funds can help you generate a steady source of income. Investors receive a fixed amount of income at regular intervals in the form of regular dividends on the bond funds.
- Even debt funds offer return enhancement with higher degree of risk, which boosts the total returns. Some fixed income assets offer the potential to generate attractive returns. Investors can seek higher returns by assuming more credit risk or interest rate risk. This is a common strategy in debt funds.
Are there any risks associates with debt funds?
In fact, there are four major risks associated with fixed income and you must have a clear understanding of these before embarking on fixed income investing.
- The most important of these is the interest rate risk. For example, when interest rates rise, bond prices fall, meaning the bonds you hold lose value. Interest rate movements are the major cause of price volatility in bond markets.
- Inflation risk is the risk of the rupee losing value due to price rise. Inflation is another source of risk for bond investors. Bonds provide fixed returns at regular intervals. But if the rate of inflation grows faster than the fixed amount of income, the investor loses purchasing power. That is measured by real returns.
- Credit risk is the risk that the issuer of debt defaults. We have seen that happen quite often in India. If you invest in corporate bonds, you take on credit risk in addition to interest rate risk. Credit risk (also known as business risk or financial risk) is the probability of the issuer defaulting on debt obligation. If this happens, the investor may not receive the full value of their principal. This is more pronounced for smaller companies.
- Last but not the least, there is the liquidity risk. This is the probability that the investor might want to sell a fixed income asset, but they’re unable to find a buyer. It could also mean liquidity risk for the fund, when it is invested in unlisted and illiquid instruments.
How to choose a suitable debt fund...
The choice of a debt fund will largely depend on your return expectations, your risk appetite and your liquidity requirement. Here are 3 things to keep in mind while choosing a debt fund for your portfolio…
- Check if your risk tolerance matches with the credit profile of the fund. If you want a zero risk fund, stick to a gilt fund as they do not carry any credit risk. If you are aggressive and can afford to take higher risk for higher returns, then you can look at MIPs, credit opportunity funds etc.
- Check out your time horizon. If you require money within 1 year do not invest in a long term debt fund where instruments will typically have a maturity of more than 5 years. You can either go for a short term debt fund or more preferably go for a liquid or an Ultra Short Term fund.
- Your choice of debt fund should be based on your assessment of where interest rates are headed as it is the most critical factor determining debt fund returns. For example, if your view is that rates are headed down, then you can focus on long term debt funds or gilt funds. If your view is that rates are headed higher, then you must either stick to liquid funds or go for floating rate funds. A word of caution! Your interest rate view must be fine-tuned in consultation with your financial advisor as it is a complex subject.
Is there any framework to evaluate these debt funds?
There are a variety of very complex methodologies to evaluate a debt fund. But from a very simple perspective, you need to consider 3 key factors while evaluating a debt fund…
- A debt fund holds a mixture of bonds ranging from 1-year bonds to 10-year bonds. The best approximation is to consider the average maturity of the fund. This needs to be compared with your time horizon. If you are looking to liquidate your debt funds with 1 year or 3 years, then look for a fund with an average maturity that approximately matches your time horizon. That will reduce your liquidity risk substantially.
- Modified duration is another measure that is quite important from the point of view of evaluating a debt fund. Technically, modified duration shows the weighted average number of years it takes to recover your principal, where interest payments are also considered as part repayment of principal. Therefore, the modified duration will always be lower than the average maturity, except in case of deep discount bond where the modified duration will be equal to the maturity. What investors need to remember here is that higher the modified duration (MD), higher is the sensitivity of bond prices to movement in interest rates?
- Yield to Maturity (YTM) is a basic measure of returns on the fund. It calculates what the bond fund will earn through dividends plus capital gains. Normally, higher the YTM, the better it is for debt fund investors.