What are debt funds ~ Know more about this important asset class

What are debt funds , Yield spread, Interest rate risk, Credit risk, Asset allocation, Mutual funds, How to invest in debt funds, Liquid Funds, FMP, Short term debt, Long term debt, Corporate Bonds
Many investors are ignorant of the advantages of investing debt funds investment avenue as an asset class. They prefer to keep funds in FD’s and other traditional debt instruments like PPF/KVP’s/NSC/Post Office etc ~ primarily due to lack of knowledge.
This post will throw some light on the different kinds of debt funds and how they work.

Investment in a debt security,  entails a return in the form of interest (at a pre-specified frequency for a pre- specified period), and refund of a pre-specified amount at the end of the pre-specified period.
The pre-specified period is also called tenor. At the end of the tenor, the securities are said to mature. The process of repaying the amounts due on maturity is called redemption.
Debt securities that are to mature within a year are called money market securities.
The return that an investor earns or is likely to earn on a debt security is called its yield. The yield would be a combination of interest paid by the issuer and capital gain (if the proceeds on redemption are higher than the amount invested) or capital loss (if the proceeds on redemption are lower than the amount invested)
Debt securities may be issued by Central Government, State Governments, Banks, Financial Institutions, Public Sector Undertakings (PSU), Private Companies, Municipalities etc.

  • Securities issued by the Government are called Government Securities or G-Sec or Gilt.
  • Treasury Bills are short term debt instruments issued by the Reserve Bank of India on behalf of the Government of India.
  • Certificates of Deposit are issued by Banks (for 91 days to 1 year) or Financial Institutions (for 1 to 3 years)
  • Commercial Papers are short term securities (upto 1 year) issued by companies.
  • Bonds / Debentures are generally issued for tenors beyond a year. Governments and public sector companies tend to issue bonds, while private sector companies issue debentures.

    Since the government is unlikely to default on its obligations, Gilts are viewed as safe. The yield on Gilt is generally the lowest in the market. Since non-Government issuers can default, they tend to offer higher yields. The difference between the yield on Gilt and the yield on a non-Government Debt security is called its yield spread.

The possibility of a non-government issuer defaulting on a debt security i.e. its credit risk, is measured by Credit Rating companies like CRISIL, ICRA, CARE and Fitch. They assign different symbols to indicate the credit risk in a debt security. For instance ‘AAA’ is CRISIL’s indicator of highest safety in a debenture. Higher the credit risk, higher is likely to be the yield on the debt security.
The interest rate payable on a debt security may be specified as a fixed rate, say 6%. Alternatively, it may be a floating rate i.e. a rate linked to some other rate that may be prevailing in the market, say the rate that is applicable to Gilt. Interest rates on floating rate securities (also called floaters) are specified as a “Base + Spread”. For example, 5-year G-Sec + 2%. This means that the interest rate that is payable on the debt security would be 2% above whatever is the rate prevailing in the market for Government Securities of 5-year maturity.
The returns in a debt portfolio are largely driven by interest rates and yield spreads.
Interest Rates
Suppose an investor has invested in a debt security that yields a return of 8%. Subsequently, yields in the market for similar securities rise to 9%. It stands to reason that the security, which was bought at 8% yield, is no longer such an attractive investment.
It will therefore lose value. Conversely, if the yields in the market go down, the debt security will gain value. Thus, there is an inverse relationship between yields and value of such debt securities which offer a fixed rate of interest.
A security of longer maturity would fluctuate a lot more, as compared to short tenor securities. Debt analysts work with a related concept called modified duration to assess how much a debt security is likely to fluctuate in response to changes in interest rates.
In a floater, when yields in the market go up, the issuer pays higher interest; lower interest is paid, when yields in the market go down. Since the interest rate itself keeps adjusting in line with the market, these floating rate debt securities tend to hold their value, despite changes in yield in the debt market.
If the portfolio manager expects interest rates to rise, then the portfolio is switched towards a higher proportion of floating rate instruments; or fixed rate instruments of shorter tenor. On the other hand, if the expectation is that interest rates would fall, then the manager increases the exposure to longer term fixed rate debt securities.
The calls that a fund manager takes on likely interest rate scenario are therefore a key determinant of the returns in a debt fund – unlike equity, where the calls on sectors and stocks are important.
Yield Spreads
Suppose an investor has invested in the debt security of a company. Subsequently, its credit rating improves. The market will now be prepared to accept a lower yield spread. Correspondingly, the value of the debt security will increase in the market.
A debt portfolio manager explores opportunities to earn gains by anticipating changes in credit quality, and changes in yield spreads between different market benchmarks in the market place. (~ source:NISM)

Remember that Debt funds are more tax efficient that FD’s. You can read about taxation on Capital Gains on debt Mutual Funds here.
Be aware of this asset class and use it to judiciously optimize your asset allocation towards reaching your financial goals. 
This article – Guide to debt funds & article – Debt funds can prove beneficial from Economic times further articulates the tax advantages & other benefits of investing in debt funds. 

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