It is a common observation that when we think or talk about mutual funds it mostly revolves around equity. It is true that equity has the potential to generate higher returns than most other asset classes in the long run. Also, in the present scenario when the markets are trending upwards after a long hiatus, the focus of the investor has shifted from lower risk debt funds which were the flavor until a few months back. Of course, equity as an asset looks attractive and is a good investment option for the long term, but you cannot write off the debt as yet.
Debt funds may not be able to generate returns similar to Equity; however, there are certain scenarios where investment in Debt Funds can be equally rewarding.
The current scenario is an opportunity for both equity and debt to perform well. Just like the onus has shifted towards more of small & mid cap themes in equity, similarly with changing interest rate scenario, slowly the focus will shift towards the long maturity funds. With RBI governor ruling that the interest rates have peaked gives an indication that there might be a rate cut sooner or later which however depends on how inflation numbers fare. RBI has pressed on controlling the inflation in order to take a call on rate cut.
Before going further, let us first understand what these debt funds are and how these can perform well in the current scenario. Debt funds are those mutual funds which invest in fixed income securities like funds that invest in income bearing instruments such as corporate debentures, PSU bonds, gilts, treasury bills, certificates of deposit, commercial papers etc. These funds are broadly categorized into long term, medium term and short term, based on the tenure of the bonds being held and its maturity profile which in turn is based on the investment objective of the scheme. These funds are categorized further based on their portfolio allocation such as, gilt funds which invest in purely government securities, and income funds, which invest in a mix of corporate debt and government securities.
There are other schemes like Fixed Maturity plans which are closed-ended and work on the concept of hold-till-maturity. They are based on the fixed maturity target and papers or securities are bought and held till maturity. These need not be actively managed. The returns are based on the yield of the papers bought and their ratings.
The main features of these debt funds are:
Lower Risk: Since these funds invest in various papers most of which are high rated, the credit risk is much lower. The schemes may take exposure to lower rated papers looking for higher returns which might increase the risk. Apart from the credit risk, one major risk in these actively managed debt funds is the reinvestment risk, i.e. when securities mature, the new papers have to be bought from market and depending upon the then interest rate scenario, new paper may give lower yields.
Tax Efficiency: Long term capital gains are taxed at 10% without indexation and 20% with indexation. If the inflation is high, there might be a case where there might be not capital gains on using indexation benefit.
How These Funds Work
These funds invest in a mix of fixed income securities which align with the maturity profile as per the scheme investment objective. These funds, which are actively managed, will take strategic calls based on the interest rate scenario. For example, if the interest rates are expected to go down, they will invest in papers with higher interest/ coupon rates and yields and for longer tenure so that they may not have to reinvest at lower yields and hang on to higher interest bearing bonds for longer duration. In the same way when the interest rates are expected to come down, funds will try and reduce the maturity of the portfolio so that they have frequent cash to invest in higher interest bearing papers.
What one need to understand here is when someone is investing in a primary market at the launch of the bond, interest/ coupon rates will be as per the scenario at that time, but when one is buying from the secondary market (an exchange) the yields will depend on the price the bond is being bought at. Now if we look at the above situations in terms of price of the bonds, when the interest rates are going up the bonds with lesser coupon/ interest will be trading at discount owing to lower demand while when the interest rates are expected to come down, the bonds with higher coupons for longer tenure will see great surge in prices as the demand will be high.
Now these debt funds have two ways to manage and generate returns. One is to hold the bonds and get regular interest which can be translated as returns for investor, and if there is a change in the interest rate direction, fund manager might take active calls by selling bonds for capital gains. Let us look at an example; when interest rates come down, higher coupon bearing bonds will have higher demand and it has double benefit of earning higher coupon or when sold in the market also attract higher bargain price thus, there will also be a capital gain apart from the high coupon which is received on annual/semi-annual basis.
Let’s assume there is a 12-year bond with 10.5% coupon which is bought at Rs 100. In case in two years time interest rates come down and new bond available with 10 years maturity offer you 8.5% and one is looking at an IRR of 9.5%. The 10.5% bond can be bought at Rs 106.28. So in case the initial buyer of the bond sells it in the market at 106.28, he would have earned a return of 12.84%. Alternatively, he can hold the bond till maturity and get 10.5% p.a.
Let’s assume there is a 4-year bond with 10.5% coupon which is bought at Rs 100. In case in two years’ time interest rates come down and new bond available with 2 years maturity offer you 8.5% and one is looking at an IRR of 9.5%. The 10.5% bond can be bought at Rs 103.2. So in case if the initial buyer of the bond sells it in the market at 103.2, he would have earned a return of 11.46%. Or one can hold the bond till maturity and get 10.5% p.a. Thus, a longer maturity bond not only gives you higher rate for longer tenure till maturity, but also provides with an opportunity to generate higher capital gains.
Case for Debt Funds
As discussed earlier, the current scenario where there is a strong possibility of rate cut and it is a matter of time, there is a case built for debt mutual funds. The case can be verified or checked based on the chart (See How Debt Instruments Fare Vis-à-vis Repo) which looks at the earlier scenario. Here the performance of the indices has been taken for reference. Individually, schemes might have performed better than the index.