Understanding debt funds

Understanding debt funds

12 Jun 2019

Debt markets and equity markets are the broad terms for two categories of markets for investments which are bought and sold. The debt market, or bond market, is the market in which investments in loans are bought and sold. There is no single physical exchange for bonds. A majority of the transactions are made between brokers or large institutions or by individual investors.

In India, bonds are issued by the Government as well as the private sector entities for the purpose of raising money for a specific purpose. They are essentially interest-bearing debt certificates. Bonds have a specified maturity period upon completion of which the borrower (i.e. Government or a Private Corporation) will return the money to the lender. The money will be returned along with the interest, specified at the time of issue, at specified time intervals.

The Indian bond market comprises of both Government and Private sector bonds but is mainly dominated by government bonds. The trading volumes in the Indian bond market have increased over the last ten years, but around two dozen entities dominate the market. Most of the participants are rated AAA, and almost 80% of the trade is direct, thus implying that the risk factor is minimized.

Mutual funds invest in debt markets and retail investors participate indirectly in small amounts through Debt Mutual Funds, which primarily invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest.

Changing / fluctuating interest rates impact a wide range of financial products, from bonds to bank loans. Bonds are the clearest example of the impact that changing interest rates can have on investment returns. When interest rates rise, the value of previously issued bonds with lower rates decreases and when interest rates go down, the value of previously issued bonds rises because they carry higher coupon rates than newly issued debt.

When it comes to mutual funds, things can become a little complicated due to the relatively diverse nature of their portfolios. However, when it comes to debt-oriented funds, the impact of changing interest rates is relatively clear. In general, bond funds tend to do well when interest rates decline because the securities already in the fund's portfolio, in all probability, carry higher coupon rates than newly issued bonds, and thus increase in value.

Let us know examine a few key points about these funds before considering any such investments:-

  • Returns are not regular but dependent on the prevailing circumstances. To cite a recent example, the returns from many dynamic and income bond funds turned negative in February 2019. There is no such assurance of getting things stabilized anytime soon.
  • Investors who are investing in debt should look at short-term funds in this current scenario of uncertainty.
  • Be sure that these funds have AAA-rate papers and come with an average portfolio maturity of one to three years.
  • In a short term fund, the investors will always benefit from accrual even if the interest rate scenario does not change.
  • AAA oriented short term and medium term funds are the best options for fixed income investors because these control both the duration and credit risks.
  • Fund managers recommend dynamic bond funds for an investor who is investing in debt for the long term. Fund managers change the portfolio in these actively managed funds on the basis of the interest rate scenario.
  • Dynamic bond funds have historically outperformed other categories over the longer term. You should not make any changes if you have parked funds in liquid, short term or ultra-short term funds for a defined period.
  • Always analyze the average maturity and the credit rating of the portfolio whenever you invest in a debt fund.
  • It is best to match your investment horizon with the average portfolio maturity.
  • There is a growth in yields due to several factors such as rising global risks, a widening fiscal deficit and inflationary pressures from the economy.

You can use debt funds as an alternate source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for the purpose of liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive the pension.

Even though debt funds are fixed-income havens, they don’t offer guaranteed returns. The Net Asset Value (NAV) of a debt fund tends to fall with a rise in the overall interest rates in the economy. Hence, they are suitable for a falling interest rate regime.

We sincerely hope that this blog has sufficiently assisted you to broaden your understanding of debt funds.

Founded in 2005 by new–age entrepreneurAbhishek Bansal, the Abans Group has evolved into a globally diversified conglomerate, providing expertise in Broking Services, Non-Banking Financial Dealings, Financial Services, Agri-Commodity Services, Warehousing, Realty & Infrastructure, Gold Dore Refinery & Manufacturing, Trading in Metal Products, Pharmaceuticals, Software Development & Wealth Management. The Group is a comprehensive financial and non-financial services and solutions provider, aiming to provide end-to-end solutions to its clients.