Understanding Debt Funds: Debt funds operate as a subset of mutual funds, employing investments in money market instruments, government bonds, and debt securities to generate returns. Debt funds are generally unaffected by market fluctuations, rendering them an investment alternative with minimal risk.
Debt funds, due to their reduced susceptibility to market fluctuations, may not yield returns as substantial as those of small, mid, or large-cap funds; nevertheless, their returns are remarkably consistent. The majority of investors who avoid market risk choose debt funds.
Pratik Shroff, Fund Manager, Fixed Income at LIC Mutual Fund, emphasizes the multifaceted nature of debt funds when it comes to long-term and short-term liability management. He emphasizes the significance of investing in suitable maturity bucket schemes to effectively manage upcoming financial obligations.
Debt funds have the potential to assist in the management of both immediate and future obligations promptly, provided that investments are made in appropriate maturity bucket schemes. “Another significant risk is credit risk,” Shroff continued.
“One can also take direct exposure to debt; however, the exit may become difficult and costly in such a case and one may not be able to adjust their portfolio based on macro-economic cycles,” according to him.
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Varieties of Debt Funds
The Securities and Exchange Board of India (SEBI), the market regulator, has classified sixteen distinct categories of debt funds according to their respective levels of risk. 16 distinct varieties of debt funds include:
Overnight Fund: The maturity date of this debt fund is precisely one day.
These funds allocate their investments towards money market instruments with maturities of no more than 91 days.
These funds allocate their investments towards money market instruments and debt with an exceptionally short duration of six to twelve months on average.
Low-Duration Funds: Debt securities with a maximum maturity of one year are the investments of these funds.
A money market fund invests in money market instruments that have a maximum maturity of one year.
These funds allocate their investments towards money market instruments and debt securities, with a portfolio duration ranging from one to three years.
Medium-Duration Funds: These funds allocate their investments across a range of three to four years, focusing on debt and money market instruments.
Medium- to Long-Duration Fund: Their portfolio duration is from four to seven years, and they invest in money market instruments and debt.
Long-distance Funds: These funds hold debt and money market instruments for an investment period that extends beyond seven years.
A dynamic bond is a debt fund that diversifies investments over time.
The corporate bond fund should invest at least 80% in AA+ bonds.
Credit Risk Fund: Minimum 65% corporate bond investment, no AA or below equities.
The minimum recommended capital allocation is 80% debt instruments, including banks, public financial institutions, PSUs, and municipal bonds.
The Gilt Fund must invest at least 80% in government securities (G-secs) of various maturities.
By investing 80% in G-secs with a 10-year portfolio duration, this Gilt Fund maintains a 10-year duration.
The Floater Fund allocates a minimum of 65 percent of investment capital to floating-rate instruments. These instruments include those that have been converted from fixed rates through swaps or derivatives.
Advantages of Debt Funds The following are some advantages to debt funds:
- Interest income and capital appreciation are consistent.
- The implementation of a diverse portfolio of debt instruments serves to mitigate risk.
- Liquidity facilitates the purchase and sale of units by investors.
- Due to their lower risk profile in comparison to equity funds, debt funds offer prudent investors a more secure alternative.
- Appropriate for investors with brief to medium-term time horizons.
How can one determine the investment risk?
While these funds are perceived as providing favorable returns, they are not without their inherent hazards. It is therefore essential to understand the associated dangers before investing in debt funds.
Increased levels of risk can occasionally accompany the appeal of higher returns. Deepak Jain of Edelweiss Mutual Funds explains that attempting to increase the interest component by investing in lower-rated instruments exposes one to the risk of capital loss under adverse conditions.
“Also, an extended usage period of the underlying securities renders them susceptible to valuation risk, given that an adverse fluctuation in interest rates can result in a decline in value,” he further elaborated.
Additionally, Deepak describes how the price of bonds can affect interest rates. Interest rate movements have an inversely proportional relationship with the price of a bond. Liquidity is an essential concern that requires strict vigilance. “Liquidity may not always be readily available through lower-rated instruments,” he added.
Additionally, one may ascertain the risks by examining the schemes managed by fund organizations.
According to financial expert Pratik Shroff, fund houses are capable of operating numerous initiatives to address credit and duration concerns. “One can look at the scheme information document of any schemes and portfolios updated by MF to identify this,” he continued.
“An optimal approach to comprehending the risks involved is to examine the Macaulay duration and percentage allocation to assets below the AAA grade of the portfolios.” “This may provide a brief overview of the strategy,” Prateek explained.
Debt schemes must choose a Potential Risk Class (PRC) matrix that represents the scheme’s maximum risk capacity, which is based on credit and interest rate risk, according to SEBI regulations. Investors can determine where to invest by consulting the matrix, he added.
Debt fund investments come with certain hazards that investors should be aware of.
Investing in debt funds carries with it certain inherent dangers. These are the hazards associated with debt funds:
- Exposure to interest risk
- Credit danger
- Liquidity danger
- Disperse risk
- Counterparty danger
- Prepayment danger
- Risk of re-investment
In the event of an increase in interest rates, the valuation of fixed-income securities declines, and conversely,. This impacts the portfolio value of a scheme.
Credit risk pertains to the potential failure of fixed-income securities issuers to repay principal or interest. A higher credit risk is associated with corporate bonds, whereas government securities are more secure.
Spread Risk: Variations in corporate bond credit spreads may affect the market value of debt securities held in a portfolio.
This pertains to the simplicity with which securities can be sold at their actual value. Insufficient liquidity could potentially result in increased impact costs.
Counterparty risk pertains to the potential for financial losses resulting from the counterparty’s inability to complete transactions.
Prepayment risk is a potential consequence of debtors prepaying loans, which can have an impact on the yield and tenor of asset-backed securities.
Reinvestment Risk: Reinvesting interim cash flows at reduced rates may lead to an unanticipated decline in the realized yield.
Who ought to invest, and how do you determine which investment is best for you?
Deepak Jain further explains that individuals desiring to invest in debt funds must adhere to the subsequent approach:
Investing in the appropriate funds is a subjective decision that varies from person to person. A conservative investor would prioritize investing in a fund characterized by low maturity and high-quality credit.
Conversely, if you possess the capacity to assume uncertainty, select investment funds that have longer maturities, lower credit ratings, or a combination of both to potentially attain greater returns while addressing liquidity concerns.
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