Debt Funds Simplified

Debt funDs
simplifieD
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[1]
Introduction ........................................................................................ 2
What is debt fund..... ......................................................................... 2
How debt funds work ........................................................................3
Gilt funds, short- and long-term funds ........................................... 5
How is it diferent from other MFs ..................................................9
Why invest in debt MFs..................................................................10
Watch out ......................................................................................... 11
Who should invest in debt MFs ..................................................... 11
How to pick the right debt fund .................................................... 12
Debt fund investment options ....................................................... 16
Using debt funds for STP and SWP ............................................. 18
Using debt funds for specic goals ............................................... 19
CONTENTS
July 2013
Debt FunDs simpliFieD
[2]
i
ts time to bid goodbye to traditional xed income prod-
ucts and, instead, embrace debt funds to achieve your
nancial goals. If you prefer steady returns and low vola-
tility, debt funds can take you a long way.
WHAT IS DEBT FUND
A debt fund is a mutual fund scheme that invests in xed in-
come instruments, such as bonds, corporate debt securities
and money market instruments, etc. that offer capital ap-
preciation. It is ideal for investors who want regular income,
but are risk-averse. Debt funds are less volatile and, hence,
are less risky than equity funds. They invest in short- and
long-term corporate and government bonds.
simpliFieD
Debt funDs
If you want to avoid the choppy markets and the erratic
returns, consider investing in debt funds
HOW DEBT FUNDS WORK
Debt funds invest in either listed or unlisted debt instru-
ments, such as bonds or corporate debt securities at a cer-
tain price and later sell them at a margin. The difference be-
tween the cost and sale price accounts for the appreciation
or depreciation in the funds net asset value (NAV).
A debt schemes NAV depends on the interest rates of its
underlying assets and also on any upgrade or downgrade
in the credit rating of its holdings. Market prices of debt se-
[3]
an investor education and
awareness initiative by hdfc mutual fund
curities change with movements
in interest rates. Lets assume,
your debt fund owns a security
that yields 10 per cent interest. If
the interest rate in the economy
falls, new instruments that hit
the market would offer this lower
rate. To match this lower rate,
there would be an increase in
your funds instrument prices as
they have a higher coupon rate.
As a result of the increase in the
debt instruments value, your
funds NAV, too, would increase.
In terms of return, debt funds
that earn regular interest from
the xed income paper during
the funds tenure are similar to
bank xed deposits that earn in-
terest. This income gets added to
a debt fund on a daily basis. If the
interest comes, say, once a year,
it is divided by 365 and the debt
funds NAV goes up daily by this
small amount.
[4]
GILT FUNDS, SHORT- AND
LONG-TERM DEBT FUNDS
Like in any other mutual fund scheme category, there are
various types of schemes in the debt fund category too. They
are classied on the basis of the type of instruments they
invest in and the tenure of the instruments in the portfolio.
Some generic types of debt funds are explained below:
Income funds. They invest primarily in debt instruments
of various maturities in line with the objective of the funds
and any remaining funds in short-term instruments such as
money market instruments. These funds generally invest in
instruments with medium- to long-term maturities.
Short-term funds. Short-tenure debt funds primarily in-
vest in debt instruments with shorter maturity or duration.
These primarily consist of debt and money market instru-
ments and government securities. The investment horizon
of these funds is longer than those of liquid funds, but short-
er than those of medium-term income funds.
Floating rate funds (FRF). The objective of FRFs is to offer
steady returns to investors in line with the prevailing mar-
ket interest rates. While income funds invest in xed income
debt instruments such as bonds, debentures and govern-
ment securities, FRFs are a variant of income funds with
the primary aim of minimising the volatility of investment
returns that is usually associated with an income fund.
FRFs invest primarily in instruments that offer oating in-
[5]
[6]
terest rates. Floating rate securities are generally linked to
the Mumbai Inter-Bank Offer Rate (MIBOR), i.e., the bench-
mark rate for debt instruments. The interest rate is reset pe-
riodically based on the interest rate movement.
Liquid funds. As the name suggests, liquid funds invest pre-
dominantly in highly liquid money market instruments and
provide liquidity. They invest in very short-term instruments
such as treasury bills and the inter-bank call money market,
commercial paper (CP) and certicates of deposit (CD) that
have residual maturities of up to 91 days.
Gilt funds. The word gilt implies government securities. A
gilt fund invests in government securities of various tenures
issued by central and state governments. These funds gener-
ally do not have the risk of default since the issuer of the
instruments is the government. They offer both short-term
and long-term plans. Short-term plans invest in securities
issued by the central government and/or a state government
with short-to-medium-term residual maturities. Long-term
plans invest in securities issued by the central government
and/or a state government with medium-to-long-term ma-
turities. Gilt funds have a high degree of interest rate risk,
depending on their maturity prole. The longer the maturity
proles of the instruments, the higher the interest rate risk.
Interest rate risk implies that there is an effect on the market
price of debt instruments when interest rates increase and
decrease. Market prices of debt instruments rise when inter-
est rates fall and vice-versa.
Interval funds. These invest in debt and money market in-
struments, and government securities having residual ma-
turity until the beginning of specied transaction periods
(STPs). Interval funds have characteristics of both open-
ended and closed-end funds. In other words, these funds
are open for subscription and redemption during the STPs.
Thereafter, units of these funds are available for trading on
stock exchanges.
Multiple yield funds. Multiple yield funds (MYFs) are hybrid
[7]
debt-oriented funds that invest predominantly in debt in-
struments and to some extent in dividend-yielding equities.
The debt instruments assist in generating returns with min-
imum risk and equities assist in long-term capital apprecia-
tion. MYFs invest predominantly in debt and money market
instruments of short-to-medium-term residual maturities.
Dynamic bond funds. DBFs invest in debt securities of dif-
ferent maturity proles. These funds are actively managed
and the portfolio varies dynamically according to the inter-
est rate view of the fund managers.
Such funds give the fund manager the exibility to invest
in short- or longer-term instruments based on his view on
the interest rate movement. DBFs follow an active portfolio
duration management strategy by keeping a close watch on
various domestic and global macroeconomic variables and
interest rate outlook.
Some other MF schemes, such as xed maturity plans
(FMPs) which invest in debt instruments with a specic date
of maturity equal to the maturity date of the scheme, also
enjoy the status of debt funds. However, it is closed-end in
nature. Other hybrid schemes that invest in a combination
of debt and equity, such as monthly income plans (MIPs)
and capital protection oriented funds, also form a part of
debt funds. By investing in all these funds, investors can take
all the advantages of debt funds.
[8]
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HOW IS IT DIFFERENT FROM OTHER
MUTUAL FUND SCHEMES
In terms of operation, debt funds are not entirely differ-
ent from other mutual fund schemes. However, in terms of
safety, they score higher than equity mutual funds. For in-
stance, when the market falls, the NAVs of your equity funds
fall sharply, whereas in case of debt funds, the fall is not as
sharp. Having said that, debt funds can offer only moder-
ate returns, while equity funds, which are highly risky, offer
high returns over longer time horizon.
WHY INVEST IN DEBT MUTUAL FUNDS
A few major advantages of investing in debt funds are low
cost structure, stable returns, high liquidity and reasonable
safety. Debt funds also score on post-tax return. Dividends
from debt funds are exempt from tax in the hands of inves-
tors. The fund, however, has to pay a dividend distribution
[10]
tax of 28.325 per cent in case of individuals or Hindu un-
divided families. While long-term capital gains from debt
funds are taxed at 10 per cent without indexation and 20
per cent with indexation, short-term capital gains taxes are
levied according to the income-tax bracket one belongs to.
Thus, debt funds can be a good alternative to investors for
achieving their nancial goals if they do not intend to bear
equity risk.
WATCH OUT
Choose the appropriate option in debt funds depending on
your tax bracket as dividend is subject to dividend distribu-
tion tax, which decreases returns. You can opt for a dividend
reinvestment option for better post-tax returns if you are in
the highest tax bracket. Else, go for the growth option.
WHO SHOULD INVEST IN DEBT MUTUAL FUNDS
Theres no xed rule as to who
should invest in debt funds. It
depends on the requirement of
investors. Different types of in-
vestors invest in different types of
debt funds. For instance, if some-
one wants to park his emergency
funds, he can go for liquid funds.
As a thumb rule, 3-6 months
[11]
household expenses can be ones emergency fund depend-
ing on the age. Roughly the amount that gives you the con-
dence to combat emergencies in your household should be
enough. Anything more can actually affect your investment
portfolio. Those in their 20s and 30s might need more, so
garner funds for about six months expenses, whereas those
nearing retirement might not need much as they would have
built up their reserves. The amount you save for an emer-
gency depends ultimately on what makes you comfortable.
If you are the risk-averse type, then you might prefer a large
fund of, say, a years salary. If, however, you are the living-
on-the-edge type, then six months salary might sufce.
For those planning to buy a home after 2-3 years, investing
in a combination of both long- and short-term debt funds
might be a good idea. Also, a debt fund can be used in the
overall portfolio for diversication across asset classes. Debt
funds can also be used for portfolio derisking when you are
nearing your nancial goals.
HOW TO PICK THE RIGHT DEBT FUND
Remember, it is the asset allocation (government securities,
corporate debt and marketable securities) that largely deter-
mines how a debt funds NAV will move. A close look at a
funds portfolio composition will give you an idea of the ex-
pected returns, risks and liquidity. So, when picking a fund,
[12]
watch out for a few things.
One, check the average maturity of the funds portfolio as
this has a bearing on your returns. The lower the average
maturity period, the lower the funds volatility and your re-
turns. On the other hand, a fund with a long maturity pe-
riod is likely to be more volatile, but the returns are likely to
be better.
[13]
Two, make sure the funds portfolio is reasonably liquid.
A large percentage of corporate debt in the portfolio does
not bode well in the short term, as it is relatively less liquid.
If the fund faces redemption pressure, it would be forced to
sell these securities at a discount, lowering the NAV. Also, be
wary of funds that hold a lot of unrated and unlisted debt.
Three, avoid schemes with small corpuses. Thats because
funds dont disclose if there are any investor who owns a
[14]
[15]
substantial chunk of outstanding units. If there are such
investors and they decide to redeem their holdings, the fund
could be forced to sell holdings below the market rates.
Four, the best tool to capture the interest rate sensitivity
of a debt fund is modied duration. It tells you how much
the price of a bond would move if interest rates move up or
down by 1 per cent. The higher the modied duration, the
greater will be the impact of an interest rate change.
Mutual funds give you access to all the information in
their offer documents and other periodic disclosures for you
to make an informed decision. It is then up to you to take
the investment decision and sign the form, or channel the
money to suit your nancial needs.
Also, you should understand how interest rate movements,
credit ratings and liquidity affect a debt funds performance.
Theoretically, if interest rates rise, the NAV of a debt fund
should fall. Thats because bond prices move in the opposite
direction as interest rates. A fall in bond prices leads to a de-
cline in a funds NAV. The opposite would happen if interest
rates fell. Of course, in an imperfect and illiquid market like
ours, this might not happen to the entire extent. Moreover,
if some bonds held by your debt fund are upgraded, their
prices would rise, leading to a drop in yields. That would, of
course, increase your funds NAV. So, be prepared for uc-
tuations in your funds NAV. Even gilt funds (which invest
only in government securities) that are advertised as the saf-
est available investments, can witness sharp uctuations in
their NAVs. Thats because prices of government securities
are a function of various economic factors, including inter-
est rates, macroeconomic data and liquidity in the banking
system. When these change, so do the gilt funds NAV.
DEBT FUND INVESTMENT OPTIONS
Ofline agent. Your neighborhood distributor helps you
choose a mutual fund scheme, brings you the forms and,
[16]
perhaps, even lls them up for you. He also helps you submit
these to the respective mutual funds besides fetching your
account statements directly from your mutual fund. But
for all these services you are charged a transaction fee of
`100 (`150 for the rst-time investor) for an investment of
`10,000 or more.
Online agent. If you prefer transacting from the comfort
of your home or ofce, you can reach out to various online
brokerages. These work with three types of accountsIn-
ternet trading account, demat account and savings bank
account with a partner bank. For a price, online brokerages
enable transactions in several instruments, such as shares
and gold, besides mutual funds.
Direct application to fund house. If you wish to apply to
a mutual fund directly, submit your application form along
with necessary documents at the mutual funds ofce or at
any point of acceptance (PoA) across the country (a list is
available in your schemes offer documents). Note that di-
rect application forms should be collected only from ofcial
centres. Make sure the box for agent code on the top of your
application is not left blank. Write Direct in it when you
submit the form to your mutual fund. Transaction charges
of `100 or `150, as mentioned above, are not imposed on
direct applications.
Funds website. Another way for direct investment is
through your mutual funds website. As this option is only
[17]
open to existing investors, you must submit physical forms
at least once to open your account with a mutual fund. Once
you get your account statement, download the online reg-
istration form, mention your folio number in it and submit
the same to the mutual fund. Your mutual fund will then
give you a code that you can use to log into your funds web-
site and transact subsequently.
USING DEBT FUNDS FOR STP AND SWP
Debt funds also allow you to take advantage of investing in
[18]
equity market along with growth on your principal amount
through systematic transfer plan (STP). With an STP, you
can transfer amounts in parts/tranches from one mutual
fund scheme to another, within the same fund house at reg-
ular intervals. Such a transfer averages the cost of purchase,
mitigating some market-related risks. Typically, an investor
rst parks his funds in a liquid or a oating-rate debt fund
and then transfers them via STP to the scheme (usually eq-
uity or balanced) of his choice at regular intervals.
Systematic withdrawal plan (SWP) is a payment option
in a mutual fund that lets you redeem units worth a pre-
specied amount at a specic intervals (monthly, quarterly,
half-yearly or annually). This is suitable for the investors
who desire periodic income.
USING DEBT FUNDS FOR SPECIFIC GOALS
Choosing funds for childrens education. When it comes
to taking the mutual fund route for your childrens future,
the basic rules of the game are essentially the same as that
for any long-term goal. But here, merely investing will not
work. You need to be cautious about the risk management
of your corpus, especially when your child is close to going
for his higher studies. Along with investing, making the
money available at a time when your child needs it is equally
important. So, here debt funds play a vital role.
With time on your side, investing in equity has many ad-
[19]
vantages. But you need to keep a close eye on the market
once you are less than three years away from your goal. One
needs to derisk the portfolio when you are nearing your tar-
gets to ensure that the gains you have earned are not wiped
out. In other words, as you near your target, start shifting
from equity to debt so as to secure your gains.
When moving away from high-risk options, you could
choose to move into liquid and short-term debt funds or
slightly riskier funds in the debt space, such as bond and gilt
funds, depending on the interest rate scenario prevailing
at that time. For instance, if the interest rates are falling,
[20]
short- to long-term bond and gilt funds would bode well. But
if interest rates remain at or move upwards, stick to liquid
funds; they are safer than the rest of the debt schemes, if not
the safest of all nancial instruments, and they would still
earn you more than your savings bank account.
The ideal way to build an adequate corpus for your childs
future is to go step by step. The sooner you start, the better.
Of course, you also need to stop along the way occasionally
to make sure things are going as planned. The closer you get
to your destination, the more careful you need to be that you
are not taking a wrong turn.
Role of debt fund in retirement portfolio. As you age, light-
en your equity funds holdings marginally; the aggressive in-
vestor should cut equity in his portfolio from 80 per cent to
70 per cent, and the conservative investor from 60 per cent
to 40 per cent. With about 15 years away from retirement,
you should start playing steady and balance your exposure
to debt and equity. For instance, the conservative investor
may choose a 10-20 per cent higher debt allocation. On
the debt side, you may look at oating-rate funds and xed-
maturity plans. Balanced funds are another option for the
semi-aggressive investor to strike a debt-equity mix.
Strategy. Follow the life stage approach to investing while
saving through mutual funds for retirement needs. As you
age, keep balancing the allocation between equity and debt.
With around 10 years away from your retirement, your pri-
[21]
ority should be to ensure the safety of your accumulated
wealth. Plan out the derisking strategy and wait for an op-
portune time to migrate your money from volatile equity to
safer debt. By the time you are 1-2 years away from retire-
ment, a large portion should have been moved away from
equity into debt funds.
Acquiring a home. Investing in mutual funds not just helps
in creation of wealth but also helps in creating assets. They
play an important role in helping one build the biggest asset
of lifea home of your own.
Paying the equated monthly instalments (EMIs) has come
reasonably within the reach for most families, especially
when both partners work. However, accumulating a big
lump sum to pay the downpayment on the house remains
the biggest obstacle. This is where mutual fund schemes
come in handy. All those who live on rent constantly won-
der why they should be throwing their hard-earned money
out as expenses, when they could use it to buy a house and
create an asset. That is more so now, when property prices
have, perhaps, settled down and when home loans are eas-
ily available as housing nance companies are offering easy
loans to customers. If you are contemplating buying a house
in 2-3 years, mutual fund schemes can help you accumulate
the money, especially the downpayment for the loan.
How they help. Generating funds from friends, relatives or
[22]
pawning gold might not be the best ways to arrange the
money. Plan early to avoid depending on such sources as far
as possible. If you feel that your personal circumstances are
right for buying a home, start by creating a savings plan for
your downpayment. Get an idea of the purchase price and
the EMI payments that you can afford. Estimate what youll
need for margin money, which is usually 20 per cent of the
home price. Thereafter, calculate how much you must save
every month.
Where to invest. If the time horizon is less than a year or
[23]
just a year away, it is
better to stash funds
in a money-market or
liquid fund. The vola-
tility in these funds is
the least as exposure
to equities is non-exis-
tent. The idea is to pre-
serve the capital and
not take undue risks
with the savings.
Choose at least two
debt funds for diver-
sications sake and
start saving through the systematic investment plan (SIP)
process. Ideally, keep the portfolio tilted towards debt even if
you are taking a bit of risk.
Strategise your moves. Remember, even debt funds suffer
from interest rate risk. So, ensure that you shift to less vola-
tile debt funds, such as short-term debt funds, at least two
years before reaching your goal. With just one year away
from your goal, shift your savings completely into a liquid
fund. Your small savings every month might not cramp your
household budget, but they will still create a lump sum big
enough to meet your downpayment needs for a home.
[24]
DISCLAIMER
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS,
READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
As part of its Investor Education and Awareness Initiative, HDFC Mutual
Fund has sponsored this booklet. The contents of this booklet, views,
opinions and recommendations are of the publication and do not necessarily
state or reect views of HDFC Mutual Fund. HDFC Mutual Fund does not
accept any liability arising out of the use of this information.
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