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Understanding Fixed Income Funds

In this episode of Dhan ki Baat, Ritesh Jain, Partner & Senior Fund Manager - Fixed Income at IIFL Asset Management, talks about the benefits of Fixed Income Funds.

1577 views  27 Feb 2018

Decoding Fixed Income Funds

Fixed Income Funds are Mutual Funds that invest in fixed income securities like government bonds, treasury bills, corporate bonds, commercial papers, certificate of Deposits etc. They are a great tool to diversify your portfolio while avoiding the market risk of a considerable loss. They present the best solution for earning consistent returns and avoiding the adverse effects of a choppy market on your portfolio.

Debt Funds invest in Fixed Income Instruments such as:

Money market instruments (having a maturity period of less than a year)

  • Treasury Bills of central government
  • Commercial Papers / Corporate Deposits
  • Bill Rediscounting

Government Bonds

  • Central government bonds
  • State government bonds

Corporate Debt Securities

  • Non Convertible Debentures (NCDs)
  • Perpetual Bonds etc.

Key Concepts of Debt Funds

To understand how debt funds work and how they can benefit you in the long run, you should understand the critical concepts related to debt funds.

1. YTM (Yield to Maturity) and Price relationship: The Yield to Maturity is a way to determine the price of a bond or any other fixed-income security. YTM is the total anticipated return on the bond if the investor doesn’t sell it until its maturity. We can measure the price of the fixed income security, and its long-term yield is given a change in the interest rates. For example, if the market interest rate rises, the prices of the bonds fall, increasing the yield. And if the interest rate falls, the cost of the securities rises and their returns become lower.

2. Average Maturity: It is the average of the maturity period of all fixed income securities held in the portfolio. This concept can prove very useful for investors to get an idea about the maturity of the securities held.

3. Duration: While talking about debt funds, duration doesn’t mean the maturity of the securities. Duration means the sensitivity level of the portfolio to the change in the interest rates. For example, if security or a bond fund is held for a long period, it will be more sensitive to the change in interest rates when compared to a bond fund held for a shorter period.

4. Credit Spread: It is the difference between the returns of two fixed income securities like bonds having similar maturities, because of the difference in their credit quality. For example, if a corporate bond of 10 years is trading at a yield of 8% and a government bond with the same maturity is trading at a yield of 6%, the corporate bond is said to offer a 200 basis credit spread over the Government Bond.

Types of Debt Funds

1. Liquid funds: These funds provide high liquidity and preservation of the capital. They invest in short-term money market instruments like Corporate papers, Treasury bills, etc. They are also called Money Market Schemes.

2. Ultra Short term/ Floating Rate Term/ Short Term Funds: These Debt Mutual funds invest in securities which has an ultra-short maturity period of 3-12x months. They often invest in Certificate of Deposit or Commercial Papers.

3. Credit Accrual Funds: These are those Debt Mutual funds which earn interest from the coupon offered by the securities as they are held in the portfolio. In other words, accrual funds buy and hold the securities in the portfolio until their maturity to earn interest.

4. Dynamic Fund: As the name suggests, Dynamic Funds switch between low duration and high duration according to the market condition. These category of funds also switch between asset segment (Gilts or Corporate Debt) depending upon their attractiveness.

5. Income Funds: Income funds focus more on current income rather than the growth of capital. They tend to invest in securities, which pay higher dividend and interest.

6. Gilt Funds: These are one of the safest funds from credit perspective as they invest in the securities backed by the government. It means that they come with Zero default risk and are safe for investing.

7. Fixed Maturity Plans: FMP come with a pre-specified maturity term and invest keeping in mind the objectives of the investor and their choice of asset allocation. The money is invested in Certificates of Deposit, Commercial paper and Corporate Bonds.

8. Hybrid funds: Also called Asset Allocation Funds, they invest in a mix of debt and equity.They typically choose to invest in shares or stocks and government bonds and other fixed-income securities.

Risk in Debt Mutual Funds

The level of risk among different Debt Mutual Funds is classified into three categories:

1. Low-risk funds: The low risk funds are usually Money Market Funds like Liquid Funds or Treasury Funds. Their high liquidity contains little chance of decreasing in their value.

2. Medium risk funds: These funds contain medium Duration risk as they are not that sensitive to the change in the interest rates. These include Credit Funds like Short-term Funds, Floating Rate Funds, and Credit Opportunity funds.

3. High-risk funds: These are debt mutual funds which include high risk or high level of sensitivity to the change in interest rates. These includes Duration Funds like Gilt Funds and Income funds. They also have relatively lower liquidity.

Why should you invest in debt funds?

Highly Liquid: You can withdraw from your fund anytime and the amount is credited in your bank account the very next day. Unlike an FD, you are not charged with any penalty if you choose to exit before the maturity (only for funds without exit load). You are also allowed to make partial withdrawal without breaking the whole investment.

Stable returns: Short-term debt funds are not usually affected by the change in the interest rates. As the returns of debt mutual funds are aligned with the prevailing market linked rates, the investor can gain from the accrual of interest. However, funds that hold securities for a longer period are more sensitive to the change in interest rates.

Reasonably safe: Most of Debt Funds invest in securities which are backed by the government like Treasury Bills, Government bonds and high quality corporate papers. If you choose to invest in these securities, you can be assured that there is a negligible chance of losing money on yourinvestments. You gain more than you lose.

Low-cost structure: Debt Funds are cost-effective in the sense that they are affordable for an investor to invest and earn capital gains. Also, in the long run they offer numerous options to save tax on your investments which can also lower the overall cost of the funds and can increase your earnings by a huge margin.

Tax benefits of Debt Funds

Debt Funds come with the benefits of saving huge amount of tax. Consider the following table:

1yr returns Liquid Fund Returns Savings Bank Returns
Pre Tax 6.30% 3.50%
Post Tax 4.04% 2.24%
* Marginal tax * Marginal tax
3yr returns Income Fund Returns/FMP Fixed Deposit Returns
Pre Tax CAGR 8.00% 7.00%
Post Tax CAGR 7.41% 4.48%
*With Indexation Benefit (assuming 5% Annual Inflation) *SBI 3-5yr FD rate
* Marginal tax of 35.88%

Dividends from debt funds are exempt from tax in the hands of investors. The mutual fund,however, has to pay a Dividend Distribution Tax, which is currently 28.325%. Long-term capital gain tax is 10% without indexation, and 20% with indexation. Short-term capital gain tax is calculated according to the individual income tax bracket.

Average Returns of the Fixed income funds across all Mutual Funds

Liquid Fund Ultra short term fund Conservative short fund Moderate Credit fund Aggressive credit Short term fund Dynamic Fund
Total number of schemes across MF 50 49 34 22 22 25
1yr average returns 6.3 5.8 4.7 5.4 6.4 1.4
3yr average returns 7.0 7.3 7.3 7.5 8.5 6.5

How to ascertain the right Debt Fund?

There are numerous Debt Mutual Funds in the market. But it is crucial that you choose the right debt fund that can assure the success of your financial plan. Before choosing a Debt Fund, do consider the following:

Set your goals before investing: There is no plan without a goal, and you cannot expect a result without it, either. Your goals should be SMART (Specific, Measurable, Achievable, Realistic and Time-bound).

Investment Horizon: Investment Horizon is generally specified by every Debt Fund which includes the specific time for which you should be invested in a particular fund.

Asset allocation of the portfolio: Before investing in any fund, look at the asset allocation of the portfolio. This means determining how much the manager invests in Governemnt security or corporate Debt.

YTM of the portfolio: YTM directly affects the return of the portfolio. Only invest if you find the YTM suitable to you.

Fund’s historic performance: Look at the previous track record in earning returns and paying dividends.

Cost of Investment: Fund management fees, administration expenses or any other entry or exit charges usually vary from one asset management firm to another; and sometimes even between two funds of the same company.

Holding period and exit load: The holding period refers to the time for which you can hold the securities with you. Also, some funds levy small fees from 0.5% to 2% (exit load) if the investor chooses to exit before the maturity of the fund.