Debt funds give higher returns than bank FDs

Investor needs to select scheme based on risk profile and tenure

Indian investors have traditionally been risk averse and prefer to invest in bank deposits. The tendency of is more towards capital preservation. Such investors can look at debt mutual funds to get slightly better returns. Depending on an individual’s profile and tenure, they can select from a range of debt funds.

Risks

Investors in debt mutual funds are exposed to interest rate risk, credit risk and illiquidity risk. Interest rate affect a scheme when prices of the securities purchased move up or down due to changes in macro-economic conditions like higher inflation, higher government borrowings, adverse effect on rupee due to higher current account deficit and other global market developments.

Credit risk means when the securities which the fund is holding get downgraded or when there is a possibility of the issuer of the security defaulting in payment of principal or interest. There are also times when the underlying securities cannot be liquidated at the price at which it is valued, due to markets not being deep enough to absorb the sale of the securities.

The debt funds offered by mutual funds can be broadly classified into three categories based on risk profile. But there’s segregation depending on the holding period required to get the desired returns.

Funds classification

Liquid funds: Investors who want to keep money for very short periods of time but want a higher interest than offered on savings account can invest in liquid funds. These schemes invest in money market Instruments which mature within 91 days. 

The underlying instruments usually have the highest short term rating which indicates the companies’ ability is very strong for payment of interest and principal. This reduces the credit risk of the portfolio. The portfolio of the fund has an average maturity of around 30 to 45 days, which reduces the interest rate risk too; longer the maturity of the portfolio, higher is the interest rate risk.

The returns of the individual securities in the portfolio are slightly above the prevailing call money rates (call money is a money market arrangement for overnight transactions between banks, and primary dealers). Investors in these funds would be getting a return close to the call money rates.

Short term bbond funds: These are variation of liquid funds but have portfolio maturity of one-two years. Bulks of the portfolio of these funds are invested in one-two year papers which gives a return of 1-2% over the prevailing repo rates.

The returns of these funds come from interest accruals and are higher than the returns generated from the liquid funds. Investors in these funds are expected to stay for three to six months to get these returns. These funds invest in papers up to investment grade (a rating for bonds having relatively low risk of default.), which indicates its ability to pay interest and principal is strong.

These funds however do have some amount of credit risks, the risk of downgrades due to expected change in companies’ profile as these investments are made for more than one year. Therefore these funds are suitable for investors who want stable returns and want less interest rate volatility.

Credit opportunities funds: These schemes invest in lower rated papers, which expose investors to credit risk. These funds normally invest in papers maturing within three years to reduce the interest rate risk on the portfolio.

The portfolios of these funds are illiquid, exposing the investors to market risk. Funds normally have exit loads to discourage investors from exiting these funds before one year. Investors can get stable returns when they invest in these funds, which are higher than the returns generated by short term bond funds.

Others: Investors can also invest in income funds, dynamic bond funds, or gilt funds. Income funds normally create a portfolio consisting of high quality corporate bonds and government securities. These funds have an average maturity of four to eight years, which exposes the investors to higher interest rate risks. The funds also have credit risk - the chance of downgrade in the corporate securities held in these funds.

However, the credit risk is lower compared to that in credit opportunities fund. The funds also have some market risk owing to corporate securities held in the portfolio; these papers are relatively illiquid compared with government securities. However, the returns expectations are higher than credit opportunity funds.

Investors can also invest in gilt funds, which have no credit risk. However, these funds have interest rate risk as they invest in longer maturity papers. The market risks of these papers are low as they are very liquid instruments. The expected return of the funds over a longer period of time is higher than the returns of credit opportunities funds.

Debt funds come in all sorts of varieties. Investors can work with a financial advisor to choose the one that works best as per their risk appetite, goals and return expectations. However fixed income products should ideally be part of every investor’s portfolio; this will help to achieve balance with equities.

The writer is Head - Fixed Income, Quantum AMC