Debt Mutual Fund – A brief Concept before you Invest

1.   What is Debt Mutual Fund?

Debt mutual funds are mutual funds that invest in fixed income instruments. "Debt" the word itself means loan. Debt mutual fund gives loans to government, businesses and financial institutions and hence Debt funds invest into fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt instruments of different time horizons. Debt mutual funds are like baskets that hold dozens or hundreds of individual securities (in this case, corporate bonds, govt. securities etc.). A Debt fund manager researches fixed income markets for the best bonds based upon the overall objective of the fund. The manager then purchases and sells bonds based upon economic and market activity. And then, this interest income that the fund receives from the bonds they invest in, is passed on to us.

2.  Advantages and Disadvantages of investing in Debt Mutual Funds?

Debt Funds are an excellent tax efficient alternative to other deposit schemes such as Bank deposits or Post Office deposits or other govt. small saving schemes. Let’s discuss their pros and cons:

(A)   Advantages of Debt Mutual Funds 

No Lock in:

An open-ended debt fund is very liquid so one can withdraw money as and when one requires. There is no lock in.

Better Returns:

Few types of Debt Funds have given few percentage point better returns than other popular deposit schemes.

Less Risky:

Debt Funds are not dependent on stock market changes and hence are significantly less volatile and less risky than Equity Funds.

Tax Efficient:

Debt funds are tax efficient in case of long term investments than many fixed deposits due to indexation benefit.

Diversification:

Each debt fund invests in number of fixed income securities and hence hedges the risk of default.

Access to Institutional Securities:

Debt funds bring you the securities in which retail investors cannot invest directly.

(B).  Disadvantages of Debt Mutual Funds

Interest Rate Risk:

Debt Funds carry interest rate risk and can add/reduce your capital based on interest rate movement.

No Control:

Investors don’t have any control over investments, as fund manager manages them.

Credit Risk:

Some Debt fund manager take credit risk to get higher returns by buying bonds of small/risky companies, which give higher interest rate but have higher chances of default.

High Expense Ratio:

Some debt funds have expense ratio of as high as 2.1% which is deducted from your total return. This expense ratios could be a high percentage of your yearly returns.

3. Risks associated with Debt Mutual Funds

No doubt that Debt Funds are safer/less risky than Equity products as these do not invest in any stock market instrument. But we should know that Debt Funds are not completely risk free either, they inherently carry 2 major types of risks and each Debt Fund type has them in different degrees:

(A)   Interest Rate Risk:

Bond prices generally rise or fall in response to interest rate changes, or like any market, the expectation of interest rate changes. Higher the maturity period of the bond, more sensitive they are to change in interest rate. During the falling interest rate period, the debt fund’s yield improves, and they give better returns and vice-versa during increasing interest rate period. This risk is maximum in Gilt Funds as their average maturity period is very high (10+ years) and least in overnight & liquid funds which have maturity of not more than 90 days. This risk can be minimized by opting for short term maturity funds or by matching your period of investment with what is called the 'maturity' of the debt funds, which can also be achieved by investing in Closed Ended FMPs.

(B)   Credit Risk:

Second risk is the risk of default by the company whose security is bought by the debt fund manager. Companies which are not much known or are new, mostly issue their bonds at higher interest rates than established players to attract investments but they carry credit risk as well. This risk is highest in Credit Risk Funds as they take credit risk to earn higher return than other debt funds. Credit Risk was the major risk that weighed in closing of 6 debt schemes by Franklin Templeton. You can minimize this risk by investing in Debt funds such as Gilt Funds, which carry negligible Credit risk as all the investment is done in Govt. Securities or in Corporate Bond funds which only invest in highest rated bonds (AAA or AA), where risk of default is minimum. 

Apart from above two major risks, Debt funds do carry few other risks too which are listed below-

i. Re-investment Risk:

Investments in fixed income securities carry re-investment risk as interest rates prevailing on the coupon payment or maturity dates may differ from the original coupon of the bond. Therefore, when the fund manager re-invest in other securities after existing maturities, they may not get the same interest rates which they got in earlier ones.

ii. Basis Risk:

The underlying benchmark of a floating rate security or a swap might become less active or may cease to exist and thus may not be able to capture the exact interest rate movements, leading to loss of value of the portfolio.

iii. Spread Risk:

In a floating rate security the coupon is expressed in terms of a spread or mark up over the benchmark rate. In the life of the security this spread may move adversely leading to loss in value of the portfolio. The yield of the underlying benchmark might not change, but the spread of the security over the underlying benchmark might increase leading to loss in value of the security.

iv. Liquidity Risk:

The liquidity of a bond may change, depending on market conditions leading to changes in the liquidity premium attached to the price of the bond. At the time of selling the security, the security can become illiquid, leading to loss in value of the portfolio.

v. Risk of Segregated portfolio:

Investor holding units of segregated portfolio may not be able to liquidate their holding till the time recovery of money from the issuer. Listing of units of segregated portfolio on recognized stock exchange does not necessarily guarantee their liquidity. Of these above risks, we have seen that in recent times due to the event of Franklin Templeton Mutual Fund closing down 6 of their Debt schemes, the Liquidity risk is gaining prominence.

4. Debt Fund vs. Bank Fixed Deposit (FD)

Many times, Debt funds are compared with Bank Fixed Deposits. No wonder bank deposits have always been the first choice of investments for low risk investors. However, the possibilities provided by debt funds have

managed to attract and encourage investors to look beyond Bank FDs. Both these investment options are very similar to each other. Primarily they can be differentiated on the basis of Returns, Safety, Liquidity and Taxation as below:

5.  Reasons to Invest in Debt Mutual Funds rather than to Invest in Debt Instruments or buy Bonds from the Market.

There are several reasons why it makes sense to invest in a debt fund rather than buy bonds from the market.

Diversification –

Many a times we under-estimate the benefit of diversification esp. in bonds. But we have seen how the fortunes of even AAA-rated bonds (for instance Dewan Housing Finance and Infrastructure Leasing & Financial Services) can deteriorate. That’s when diversification helps. Debt Funds typically invest in large number of bonds to diversify and hence reduce the risk on investment. However, if you buy bonds directly, you may find it cumbersome to assess multiple issuers, even if you have a decent sum of, say, Rs 10 lakh to deploy. But a debt fund can help diversify.

Better Taxation - 

If you do not require regular monthly income, then investing in bonds brings unnecessary tax liability. Interest from bonds is added to your income and taxed at your slab. A debt fund works better. You only pay tax when you sell your fund. If units of bond funds are held for more than three years, your capital gains are taxed at 20 percent after indexation. This effectively postpones and reduces the tax burden. Tax benefit is large for high tax bracket individuals and low for low tax bracket individuals.

Lower investment amount required –

Small investors may find it difficult to invest in overnight bonds or government securities due to the larger lot sizes.

Better liquidity –

Indian bond markets are very illiquid. You might have been tempted to buy a bond with a higher interest rate. But high yield bonds are also lower-rated and therefore less liquid. That’s just a typical scenario. But if the macroeconomic situation worsens, like it did last year due to COVID-19, then such bonds can sink. Many bonds have very low trading liquidity in the secondary market or even if they do, there is a significant discount to the fair value. Investors in bond funds have assured liquidity at net asset value. Though the Franklin Templeton episode has shaken many investors’ confidence in bond funds on this front, well-managed bond funds from reputed mutual fund houses would still be much better than investing directly in bonds.

Ease of reinvesting –

If you hold bonds and fixed deposits, then you would be getting periodic payments towards interest in your bank account. Many a time, such interest received in the bank account stays there unnoticed. Sometimes it gets spent and sometimes it gets deployed at a later date for reasons such as small size of the amount or lack of time to do so. When you invest in a growth plan of bond fund, all the receipts are redeployed in the best possible opportunities available.

Though investments in bond funds appear beneficial, you cannot ignore the cost associated with them. In a low interest rate regime, the expense ratio of the bond funds – a recurring cost – eats into your returns.

6. Who can invest in Debt Mutual Funds?

Debt mutual funds are considered to be low-risk investment options. The returns are usually not affected by fluctuations in the market. Debt mutual funds invest in securities which generate fixed income like treasury bills, corporate bonds, commercial papers, government securities, and many other money market instrument. Debt funds are highly recommended to investors with lower risk tolerance.

Debt Funds are great for –

>          Emergency Fund Investments 

>          Managing your Debt allocation 

>          Long term Debt Investments for high income tax payers 

>          Investments for your short term goals 

>          Cash allocation for investing in Equity on dips 

>          Regular Income for Retirees 

Always, remember – You should not invest in Debt funds to get higher returns, you should invest in debt funds to protect your investments.

7. How are Debt Mutual Funds Taxed?

From taxation purpose, all the funds which invest less than 65% in Equity are considered as Debt Funds. So many hybrid funds categories like Conservative Hybrid Fund and Capital Protection Funds are taxed as Debt Funds only. Even International Funds are taxed as Debt funds only.

Short-Term Capital Gain- 

When Debt Mutual Funds are sold within 36 months from the date of purchase, the profit or loss on redemption is known as Short-Term Capital Gain or Loss (as the case may be). Short Term Capital Gain is taxable as per the normal tax slab rate and indexation benefit is not available for the same.

Example:

Mr. Ayush purchased Debt Mutual Fund Units on 15.06.2016 for ₹ 1,00,000. The said units were sold on 20.02.2019 for ₹ 1,26,000.

Now, MF units are held for less than 36 months before the sale date. Therefore, it will be considered as Short- term capital asset. Short Term Capital Gain (STCG) will be calculated as below-

Now here, STCG shall be taxed at a normal tax slab rate. So, if you tax slab is 30%, your will have to pay 30%* 26000 = 7800 as capital gain tax.

Long-Term Capital Gain-

When Debt Mutual Funds are sold on or after 36 months from the date of purchase, the profit or loss on redemption is known as Long-Term Capital Gain or Loss (as the case may be). Long-Term Capital Gain on redemption of Debt funds is taxable @ 20%. Indexation benefit is available in case of LTCG.

Example:

Mr. Ayush purchased Debt Mutual Fund Units on 21.04.2014 for 2,75,000. The said units were sold on 17.10.2018 for 4,50,000. Calculate Capital Gain considering CII (Cost Inflation Index) of FY 2014-15 as 240 and CII of FY 2018-19 as 280.

Now, MF units are held for more than 36 months before the date of Redemption. Therefore, it will be considered as Long-Term capital asset. For calculating LTCG, we first need to calculate the indexed cost of acquisition.

Calculation of Indexed Cost of Acquisition

The indexed cost of acquisition calculated above, shall be reduced from the amount of redemption.

Calculation of Long-Term Capital Gain (LTCG)

Capital Gain tax irrespective of Tax slab will be 20%1 29,167 = 25,833.40

8. What are Expense Ratios of Debt Mutual Funds?

Like any business that charges you for their services, mutual funds, too charge a fee for managing your money. This includes the fund management fee, agent commissions, registrar fees, and selling and promoting expenses. All this falls into a single basket called total expense ratio (TER) that is disclosed on a monthly basis and is expressed as an annualized percentage of the fund’s net assets. TER is deducted every day from fund’s NAV. So the returns which you see on websites and fund’s documents are all post Expense Ratio returns.

Each fund scheme has two different plans based on TER - Direct & Regular. Only difference between these two plans is different TER.

Regular plan has higher TER as it includes distributor’s commission too. If you are buying Mutual Funds through Distributors or Bank websites, you will only see Regular plan option for investments. Example HDFC Corporate Bond TER of Regular plan is 0.6%.
Direct Plan has lower TER as distribution commission is not deducted in this plan. These plans are offered by various websites & apps these days like Paytm money, Groww, Kuvera, etc. Example, HDFC Corporate Bond TER of Direct plan is 0.3%. So, in Direct plan, you will get 0.3% returns more every year.