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Best Debt Mutual Funds

Scheme Name AUM(Cr.) 1y % 3y % 5y % Expense Ratio(%)
Bank of India Credit Risk Fund - Regular166.26140.6913.2301.56
Aditya Birla SL Medium Term Plan (G)1628.0623.249.3501.51
Bank of India Short Term Income (G)45.1617.196.8301.05
Franklin India STI (G) (Wound up)504.7114.89500.04
UTI-Dynamic Bond Fund (G)396.3713.248.6501.56

Debt funds, as the name suggests, invest in fixed income debt instruments. Debt instruments pay regular interest and also redeem the principal on the completion of the tenure of the instrument. For example a 9% bond redeemable after 5 years with a face value of Rs.1000 will pay Rs.90 as interest each year and at the end of the fifth year it will pay Rs.1090, which will include the redemption of the principal. Compared to equity funds, debt funds are lower on the risk scale and also give more stability and regularity to income flows, which is why it is more preferred by conservative investors. Like equity funds create a pool of equity assets, debt funds create a pool of debt assets which include government bonds, corporate bonds, treasury bills, commercial paper, certificates of deposit etc.

Debt funds are typically classified based on their duration or their credit risk. In terms of duration, a debt fund can be a liquid fund, short term debt fund, income fund or a long term gilt fund. In terms of credit risk, debt funds can be classified as G-Sec funds or credit opportunities 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.

Debt funds and equity funds differ on the assets that they invest in. While equity funds are predominantly invested in large and mid cap stocks based on their investment objective, debt funds spread their funds between various debt instruments. Here are some key differences.

  • Equity funds create a portfolio of stocks while debt funds create a portfolio of bonds. Equity funds choose from small cap, mid cap and large cap stocks. Bond funds have a choice of liquid bonds, call money, G-Secs, corporate bonds and CPs to choose from. Both offer the benefit of diversification.
  • Equity funds carry a higher total expense ratio compared to debt funds. That is because equity funds entail a higher degree of active management and factor tracking. Also the returns on equity funds are relatively higher over a longer period of time. In case of debt and equity funds, the TER is adjusted to the NAV on a daily basis.
  • Equity funds are ideally meant to generate long term wealth. Equities have outperformed other asset classes over longer periods of time and a diversified equity fund can achieve that. In case of debt funds, the focus is more on generating regular income, adding stability to the portfolio and to reduce the overall risk of your financial plan.
  • In case of open ended equity and debt funds, the entry and exit is free. However, the debt funds tend to be more liquid for two reasons. Firstly, the risk of price loss is lower and the impact cost is quite low.

A common question that a lot of debt fund investors have is whether the NAV of a debt fund can actually fall since the fund is invested in assured return bonds. NAV or the Net asset value of the fund is the market value of its bonds (minus expenses) divided by the number of units outstanding. There are two common cases where the NAV of the debt fund can fall.

  • When interest rates go up and the bond yields go up in the market. The signal is normally given by the RBI hiking repo rates in the monetary policy. When bond yields go up, the existing bonds will become less valuable as the same bonds are now available in the market at better yields. To compensate for the loss in yields, the price of this bond will fall. That leads to a fall in the NAV of the bond fund. This is not a problem for very short term funds but only for long term gilt and income funds.
  • Another unique case of a crash in NAVs arises when the bonds held by the fund come close to default. We have seen that happen in case of IL&FS recently and in the case of Amtek Auto in the past. How does this happen. When a company like IL&FS defaults, the rating agency sharply downgrades ratings of its bonds. Investors start demanding sharply higher yields on these bonds and to compensate for that the bond prices started falling. This can lead to capital depreciation and reduction in NAV. In the aftermath of the IL&FS crisis, BOI AXA Debt fund which held an Rs.100 crore stake in IL&FS wrote off the entire amount leading to 5% erosion in its NAV in a single day.
  • In the case of liquid funds the NAV erosion is normally not a concern. However, in case of Short term funds and UST funds, NAV erosion can be a challenge when the yields at the short end go up sharply due to liquidity shortfalls in the market.

Choosing a debt fund typically involves the following four stages that you need to navigate.

  • First assess what is your risk appetite. If you have a low appetite for credit risk then you should ideally stick to liquid funds at the short end or G-Sec funds at the long end. Also look at your appetite for interest rate risk. If you have a low risk appetites then don’t go too long on the duration. Also avoid debt funds that rely too much on fund manager discretion for investment.
  • Match the debt fund to your risk profile. There are two implications to this. Firstly, if you have medium term goals then you can afford to take the risk of G-Sec or Income Funds but if your goal is shorter then you should stick to liquid funds or to UST funds. Secondly, the credit risk that you take on these funds will also be a function of whether you can wait long enough to match the fund to your risk profile.
  • Evaluate alternatives before investing. This is an important step while investing in debt funds. Ensure that you evaluate alternatives based on returns, risk, maturity profile, asset quality etc. You just can't look at returns because if the fund manager is earning higher returns by exposing you to more volatility then it does not make sense. Also look at the most tax efficient option for realizing your gains on the fund.
  • ➢Don't forget the expense ratio. Expense ratios on debt funds are lower than equity funds but even at around 1.50%, the total expense ratio (TER) can make quite a dent on your returns. Given a choice between two funds with similar risk and return profiles, prefer the fund with a lower TER. It makes a big difference in the long run.

Fund selection is only one part of the story. Once you invest in a debt fund you need to evaluate the fund on a regular basis and also evaluate the need to rebalance your debt fund portfolio if required. Here are five points to consider.

  1. Firstly, look at returns and benchmark it to the index and the peer group. If other bond funds are giving 10% and your fund is consistently earning 150 bps lower than the peer group then you need a change in strategy
  2. Secondly, be cautious on fund that generate alpha with higher risk in the books. Higher risk in debt funds can come in the form of longer maturities. This can giver higher yields but can also be dangerous in a rising interest rate scenario. Secondly, risk also comes from the quality of debt. A small exposure to AA rated funds is OK but be cautious of funds that are generating returns purely out of higher risk.
  3. Is the debt fund still in tune with your goals? That is question you need to constantly keep asking yourself. This will ensure that your fund portfolio is in sync with your long term and medium term goals as that is the core purpose of including debt funds into your portfolio.
  4. Look for drastic changes in the debt fund that you are holding. Be wary of sudden changes in objectives or a drastic change in portfolio in favour of long maturity debt or lower rated debt. These can be triggers for a switch out of the fund. If the top management of the fund including the CEO, CIO and the fund managers are seeing constant churn, you need to be wary. Start looking for alternatives.
  5. Finally, don’t miss out looking at the duration of the portfolio. Duration of the bond portfolio has two important implications. Firstly, it shows you the sensitivity of your portfolio to movements in rates. Higher duration means higher negative impact if rates risk and higher positive impact if rates fall. Secondly, duration is also used for matching liabilities. If your debt fund is matched to a liability payable after 5 years then focus on a fund with average duration of around 5 years. Otherwise you are exposed to price risk.

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