When you talk of investing in mutual funds, it usually means equity mutual funds. Equity funds invest most of the money in stocks. You also have ELSS, which is a type of tax-saving mutual funds. ELSS invests most of the money in stocks and you enjoy the Section 80C benefit up to Rs 1.5 Lakhs a year.
Let’s understand what are debt funds and things to remember before investing in a debt mutual fund. Want to know more on debt funds? We at IndianMoney.com will make it easy for you. Just give us a missed call on 022 6181 6111 to explore our unique Free Advisory Service. IndianMoney.com is not a seller of any financial products. We only provide FREE financial advice/education to ensure that you are not misguided while buying any kind of financial products.
See Also: Taxation of Debt Funds
How to invest in debt funds? Debt funds are not like the simple fixed deposits where you just lock your money and enjoy interest. There are several types of debt funds meant for short-term, medium term and long-term investments. Some debt funds are not risky while some are really risky.
Choose the debt mutual fund based on investment horizon and risk profile. If the investment horizon is a few days or weeks, invest in liquid funds where most of the money is put in money market instruments like commercial paper, treasury bills, and certificates of deposits and so on. For a time horizon of a few months to a year, invest in an ultra-short-term scheme. If you need money in a few years, invest in a short-term scheme.
Income Funds: The value of a debt fund is measured through Net Asset Value or NAV. Income Funds give good returns in both rising and falling interest rate scenario.
Income Funds invest in high dividend generating stocks like Coal India, REC and so on, Government Securities, CDs, Corporate Bonds, Debentures and Money Market Instruments.
Income Fund Managers have two strategies:
The fund managers aim to generate high returns by allocating funds towards debt and money market instruments which are investment grade. These have low-interest rate risk. Interest rate risk is the risk that an investment’s value will change, because of a change in interest rates.
Remember: Changes in interest rates affect debt mutual funds. This is true for long term schemes. When interest rates rise, prices of bonds fall and this means NAV of debt funds go down. In a falling interest rate scenario, bonds prices rise and NAV of debt funds goes up. When interest rates fall, bond prices rise and vice versa.
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Dynamic Bond Funds: In dynamic funds, the fund manager keeps changing the portfolio composition in-line with the changing interest rate regime to generate maximum profits. The fund manager takes a call depending on the interest rate scenario and invests in debt funds of shorter and longer maturities.
Short Term Funds and Ultra Short-Term Funds: These invest in fixed income instruments of short maturity. The maturity period ranges from a year to 3 years.
Liquid Funds: These invest in debt instruments with maturities up to 91 days. They are almost risk-free. Mutual Funds offer instant redemption on liquid funds.
Gilt funds: Gilt funds invest in Government Securities and have low credit risk. Governments seldom default and this makes it a good investment for risk-averse investors.
Credit Opportunities Funds: These funds invest in taking a call on the credit risk instead of the maturity period. Credit risk is the risk of default. These funds invest in lower-rated bonds that offer higher interest rates. This makes them extremely risky.
Fixed Maturity Plans: Fixed Maturity Plans or FMPs are closed-end debt funds. FMPs invest in Corporate and Government Bonds. They have a lock-in of a few months to a few years. FMPs are tax-efficient and give higher returns than FDs.
See Also: Public Sector Banks in India
Debt funds invest in the paper of Companies that sometimes fail to meet repayment obligations. They default on interest or principal payments called credit risk. This is the danger of investing in debt funds.
Some debt funds invest in lower-rated Company papers to generate higher returns. Sometimes, Companies default on their obligations and you run the risk of losing money.
Credit Rating Firms like CRISIL downgrade the debt of these Companies, leading to a fall in the NAV of debt schemes.
A few months ago a reputed Company IL&FS suffered a downgrade in ratings. The long-term ratings of the parent entity IL&FS were downgraded multiple notches from AA+ to BB on September 8th and then to D on September 17th 2018.
Many fund managers of reputed debt mutual fund schemes had a high allocation towards IL&FS in the portfolio. The NAV of these debt schemes would go down.
SEBI has allowed fund houses resort to side pocketing. The side pocket option allows mutual fund houses to separate bad and risky assets from other liquid investments in the debt portfolio. This reduces the impact of underlying instruments affected by credit profile like in the IL&FS case. Small investors remain protected from the exits of large investors.
How does side-pocketing work? Let’s understand side-pocketing through an example. There’s a fixed income fund with a corpus of Rs 5,000 Crores. It has an exposure of Rs 300 Crores to a defaulting Company. The remaining Rs 4,700 Crores are in reputed Companies.
When the news of the defaulting Company comes out, large investors head for the exit as they rush to redeem money from the debt scheme to avoid more losses. With heavy redemptions, all money rushes out of the fund. Fund Managers have to sell good papers for the redemption as most buyers exit. This means the percentage of bad assets in the portfolio rises leading to a crash in debt fund NAVs. This affects small investors as well.
This is where side pocketing helps. The mutual fund segregates the debt papers of the affected Company, while the good papers remain unaffected stabilizing the NAV of the debt funds. The investors of the original debt fund get units of the side pocketed funds. When the affected Company bounces back, the investors get back their money.
SEBI has very strict rules when it comes to the offending fund manager. SEBI has given permission to the Trustees of the Fund who segregate portfolio’s to penalize managers who have purchased these securities. They are penalized by having their bonuses taken away and added to the affected scheme. This generates higher returns for the investors.
See Also: Functions of SEBI
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