UNDERSTANDING DEBT MUTUAL FUNDS

Mutual Funds are a vehicle of investments that offer the retail investors a chance to achieve growth, wealth creation as well as a capital protection. Broadly, these funds are categorized into two families i.e. Equity Mutual Funds & Debt Mututal Funds. These two differ in their investment objectives, structure, potential returns as well as taxation on the capital apppreciation gained.

Mutual Funds are often viewed as one segment or group of schemes that invest pooled funds in the capital markets and are “subject to market risk”. Taking a deeper view on these products should help the investors in becoming more informed about these products and realize that each scheme under a category of fund is diffwerent in its investment objective and its purpose. This is vital since each investors have different risk appetites and expectations from the market, making the choice of the fund an important decision.

This article is an effort towards explaining the different nuances of Debt Funds. As you can see below that debt funds have various sub categories. Here, we have tried to get into the 7 different sub categories, explain how they have been structured & the investment objectives under each. The taxation of these products is the same across all sub categories, therefore we will discuss that right at the end.

There are two terms that investors must be aware of while determining their choice of Debt Funds. It is the Average Maturity and Modified Maturity of the securities held by the fund. These two play a vital part in determining the Fund’s (particular scheme’s) volatility.

Average Maturity/Duration: Debt Funds hold debt securities such as Bonds (corporate as well as PSU), NCDs, Commercial Papers as well as Corporate Deposits to name a few. Each instrument within the Fund has a separate time to maturity. The average maturity tells the investor the weighted average of the instruments’ time to maturity as per the percentage of the holdings in each. Investors may wonder as to what is the significance of this? As a standard indicator, the Average Maturity tells the investor how volatile the NAV of the Fund will be to the Interest Rate Fluctuation. Explained very simply, when the expectation of the interest rates is that they will go down, then investors generally place their money in Funds that have a higher average maturity to benefit from the rising interest rates.

Modified Duration: Modified duration is a concept that is similar to Average Duration but its difference is that it is used to approximate the change in price of a Debt security due to the change in yield of the same instrument. A simplified formula for the calculation is the following:

Change in price of the Bond = (-) Modified Duration * % change in yield

For instance this formula calculates that if the modified duration of the bond is 5yrs and the yield falls by 2% (due to external factors such as change in interest rates) the consequent change in price could be close to 10%. The negative sign denotes the negative or inverse relation between the price of the bond and the yield.  Basically, modified duration measures the sensitivity of the Bonds Price to interest rate fluctuations.

Below we have explained the different type of Funds that are available and apt for retail investors. We have left out Liquid Funds, Ultra Short Term Funds and Short Term Funds for a simple reason that they are more apt for short term investments and not a priority for retail investors. The following funds, explained below, are used by retail participants to get a mix of capital appreciation along with some level of security.

Debt Dynamic Bond Funds:

As the name suggests Dynamic Bond Funds invest the pooled funds of the retail investors into Debt Instruments (Fixed Income Securities) of varying maturity. The key difference between these funds and Debt Income Funds is that the fund manager has a wider range of Debt Instruments to make the investments. Debt Income Fund on the other hand generally chooses long term Debt instruments to make the investments.

For the investor the critical point to take notice is that while investing in these funds the investor does not need to worry about timing the markets. What this means is that he is able to park the money in these funds without concerning too much about the timing as compared to the external economic factors. Debt Dynamic Bond Funds according to the mandate of the fund have greater flexibility and wide range of maturities of instruments as compared to Debt-Income funds thereby mitigating the risk.

Debt-Income Funds:

Debt income Funds when compared to Dynamic Bond Funds are for investors that have a long term view on their investments (greater than 5 years). These funds, by mandate, invest the funds into corporate bonds, government securities as well as money market instruments. Ideally, one should look to invest in these funds when one feels that the market interest rates have reached their peak and will move downwards from here on. This is so because the fund mandate requires a certain percentage to be always held in corporate bonds, government securities and this affects their Average Duration of the fund. As we have mentioned before the average duration of the Debt Income Fund is quite high which makes it more sensitive to rate changes and external factors. While this is true, these funds also have a benefit which is that they have income accruals too. The interest from the debt securities gives the fund the option to not only attain capital gains but also earn from the interest accrued to each security held.

Debt Credit Opportunities Funds:

These funds are those that make investments into the securities adopting the accrual strategy to achieve return.   Accrual Strategy refers to earning through interests of the individually held debt securities. The investor should understand the nuance involved here. The Fund manager would try to choose those securities that promise the highest returns in terms of interest on the Debt Securities. Be careful, this strategy does not involve the Duration Play (which is holding bonds and instruments that have a longer duration in order to benefit from interest rate falls, vice versa). So a Credit Opportunities Fund will generally pick out those securities that offer a high interest rate as well as have the most potential to grow. This decreases the risk from default whereas enhances the chances of getting an upgrade in the security.

Gilt Funds:

These Funds look to invest in securities that are issued by municipal bodies or government institutions (state and central). They hold securities that generally have a medium to long term time to maturity. This makes these funds vulnerable to the capital fluctuations in an environment of changing interest rates. On the other hand, these funds have the lowest chance of default since government issued securities always pay out the coupons and interests accrued to the holder.

Debt-Oriented Hybrid Funds:

These funds look to allocate the funds between the Equity and Debt Instruments. It is a mandate to employ more than 65%-95% of the Fund towards Debt Securities whereas the exposure to stocks is limited to 5-35% at most. The Equity and Debt Markets have a low level of correlation, thereby keeping both sides of the investments exclusive and not hinged to each other. These funds generally get an edge over the other Debt Funds in terms of the returns they generate but it goes without saying that the same is accompanied by a certain degree of risk.

TAXATION OF DEBT FUNDS

As per the budget presented by our Finance Minister in 2016 there were no changes to the definition of Long Term and Short Term for Debt Funds. This differentiation is significant as it affects the way that these products are taxed. Long term period of investment is considered to be any investment over and above 3 years time frame. Any investment redeemed before 3 years is considered a short term investment in the Debt Markets.

Now comes the part of taxation. Short Term Capital Gains Tax in a growth plan is charged as per the income slab of the individual. This means that the profit that I have made (remember only the profit) on the investment will be added to my annual income and will be taxed as per the tax slab.

Long Term capital Gains are treated differently and favorably for the long term investors. The gains are taxed at a flat 20% after Indexation. To explain indexation very simply, it is the price adjustment of inflation. So in effect the returns from the investment, for the long term investor, are adjusted for the inflation over the period of investment and then the adjusted returns are taxed at 20%. This aspect of Debt Funds makes them more lucrative as against term deposits offered by Banks.

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