If you thought mutual funds were primarily about investing in shares or the equity market, think again. Mutual funds extend beyond the limits of equity. They also invest in Debt Instruments. The same principle higher the risk, the higher the returns applies here. Debt products are lower in risk as compared to equity funds.
Debt funds are also known as Fixed Income Funds or Bond Funds and they invest only in debt securities. Some examples of debt securities are as follows:
- Corporate Debentures or bonds
- Commercial papers
- Certificate of Deposits
- Government Securities or bonds
- Treasury Bills
Unlike in equities, where one is part owner of a company to the extent of their share holding, an investor isn’t an owner in the case of fixed income investments. But on the upside, an investor is a lot more aware of the key variables involved, such as:
- Reasonable assurance that the principal will be returned.
- Tenure post which the principal is returned.
- The coupon rate, or simply put, the interest rate.
So the great thing about debt funds is that they are designed primarily to protect your capital and provide stable returns by investing in debt securities.
How does your money appreciate in a debt fund?
Broadly, there are two independent sources of revenue through which a debt fund earns:
- Interest Income
- Mark to Market gains
Understanding Interest income
When you invest in a Bank/Company deposit it offers you a fixed rate of interest with the principal being returned on maturity. Similarly when a debt fund invests in various debt securities the issuers of these securities offer a rate of interest and the principal on maturity.
For example, let’s say a debt fund with a starting NAV of Rs 100.00 buys an Rs 100 GoI security, paying an 8.5% interest semi-annually with a maturity of 5 years. The debt fund would earn Rs 8.50 annually and get back the principal of Rs 100 at the end of 5 years.
Consequently, what the debt fund does is that it spreads the Rs 8.50 of interest it earns annually over the 365 days of the year, earning Rs. 0.0233 per day.
Understanding Mark to Market
Similar to interest rates on Bank Fixed Deposits, the interest rates on debt securities also change. In fact, you could say that interest rates and debt security prices are on either end of a seesaw. Prices fall when interest rates rise and rise when interest rates fall. For example, if the interest rates were to decline, then the newer bonds would be issued at a lower interest rate than the existing bonds. Consequently, the value of the older bonds will increase, leading to a rise in their price.
In the same way, if the interest rates were to increase then the value of the old bonds would fall and the newer bonds would bear higher interest rates. So it’s extremely probable that the traded price of a bond will differ from its face value. Hence the longer a bond’s period to maturity, the more its prices tend to fluctuate, owing to the constantly changing market interest rates.
To further illustrate, here is an example:
If interest rates decline and the GoI issues new 5 year bonds at an interest rate of 7.5%, it leads to an increase in the value of the old bonds to 8.5%. The price of older bonds will increase from Rs. 100 to Rs. 105. If the old bonds are now sold, the buyer will now receive Rs 8.50 per year for 5 years but will make a loss of Rs. 5 on redemption of the principal at the end of 5 years. The investor, therefore, earns Rs. 42.50 by way of interest, over the course of 5 years and loses Rs. 5 on the principal amount invested, giving him a return of Rs 37.50 over 5 years which is equal to the new bonds.
On the day the old bond price is marked up to Rs. 105, the NAV of the fund will increase by Rs. 5.00 but from that day onwards the daily interest income will decrease from 8.5% p.a. to 7.5% p.a.
What are FMPs?
Fixed Maturity Plans are closed ended debt mutual fund schemes. Simply put, a closed ended scheme is one where you can invest only during the new fund offer period, post which it is shut for new subscriptions. As the name suggests, it has a fixed time horizon and the money is given back to you upon the expiry of this period.
The time horizon can rangeanywhere from as low as 30 days to even 5 years. Since the maturity and the money are known beforehand, the fund manager can invest with reasonable confidence, in securities that have a similar maturity as that of the scheme. Thus if the tenure of the scheme is 1 year then the fund manager will invest in debt securities that mature just before 1 year. What also helps is the fact that there can be no redemptions in these schemes, unlike in other open ended funds, where one can buy and sell units from the asset management company. At most,you can sell units to other investors over the stock exchange, but the overall quantum of money that is collected during the NFO remains the same.
One important thing to remember is that here too; the returns are neither indicated nor guaranteed.
What is average maturity and how is it useful?
Debt funds invest in a number of debt instruments, all of them having a varying maturity. That’s where the average maturity comes handy. As the name suggests, it basically indicates the average maturity of all the securities in a portfolio, giving you the freedom to compare.
Average maturity thus gives you a quick glimpse into the sensitivity of the bond to interest rates. Funds with higher average maturities tend to be more volatile in the short term since their objective is to deliver higher returns over the long term. Simply put, a fund with an average maturity of 5 years is definitely more volatile in the short term than a fund with an average maturity of say 9 months. That’s because in the shorter term there is reasonable surety on the receipt of the coupon income.
So matching your investment horizon with the average maturity is always a good idea. But remember, an average maturity of say 4 years doesn’t necessarily mean that you have to hold it for 4 years. But it definitely indicates is that you can expect to get optimal returns, given the interest rate environment, over 4 years.
Exit load isan effective mechanism that prompts investors to stay invested through the desired holding period. This ensures that investors, who move in and out of the fund and take away accrued gains during momentary positive market movements, do not short-change diligent investors who stay invested for the entire course.
Why is it essential to match the investment horizon with that of the scheme?
Funds having a lower average maturity are ideal for short-term holdings as they are well protected from the fluctuating interest rate movements. However, holding them for more than their average maturity may not get you the optimal results.There can be various types of debt funds based on the average maturity of the instruments invested in. Although debt funds are less risky than equity funds, they are still subject to market volatility.The level of volatility therefore depends on the average maturity of the specific portfolio.
The higher the average maturity, the greater the uncertainty in the short term, which is what results in greater volatility. Conversely, the lower the average maturity, the greater the certainty, which in turn lowers volatility.
Liquid funds are the least volatile as their maturity is in days and at the other extreme there are income funds, where the average maturity is in multiple of years.
So in order to really get the most out of debt funds, it is essential that you match your investment horizon with the average maturity of the scheme.
What are Money Market or Liquid Funds?
Liquid funds are also known as Income Funds. Their aim is to provide easy liquidity, preservation of capital along with moderate income. These schemes invest exclusively in safer, short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds and are most appropriate for corporate and individual investors as a means to park their surplus funds for short periods.