Debt Funds: How to select?

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Debt Funds: How to select?

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By Sanjeev Kumar, ICFAI Hyderabad

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An alternative investment avenue that has gained importance all over the world in the past decade is none other than mutual Wealthdaily.com/Gold_Report funds. At present, in the mutual fund industry major part of fund comes from HDFC Fixed Deposits retail investor. This entire corpus is invested Highest HDFC Deposit Interest in both in equities and debt instruments. Rates Safe & Secure, Invest Mutual funds have emerged as a substitute Now! www.HDFC.com/Deposits to invest in government securities and money market instruments that are out of reach of individual investors. Now, the mutual funds schemes are diversifying into other spheres of investment, and they are eyeing commodities like gold, silver etc as the next investment avenue. Stock, market Volatility has proved that debt market still a safe place for keep ones earning. This article studies the importance of debt fund in the portfolio, and the steps taken to select as right fund. Before going on to a detailed discussion let us discuss the dynamics of debt fund. Basically debt funds are the mutual fund schemes that invest their entire corpus in government securities, corporate bonds and other money market instruments with a prime objective of providing steady returns in the short run and capital appreciation over the long term horizon. However in practicality, the asset management companies keep an option to invest maximum of 10% or 25% of their corpus in equity stocks so as to generate more returns for the investors in the short run. One of the major advantages of the debt fund is that the capital invested is virtually risk free, i.e. the risk averse investors who are scared of their capital being eroded elsewhere can freely invest in debt fund with stable and almost fixed returns over the investment period. There are investors who still park their surplus fund in a savings bank deposit or in a fixed deposit account that offers a fixed rate of interest with the principal being redeemed on maturity. Instead of putting their fund in bank deposits which now currently offers very low interest, it is always recommended to invest in debt funds. Some of the unreasonable investors are of the view, that the mutual fund investments are carrying huge default risk, and may wind up their business and exit the market. When a fund invests in debt instruments, the issue$ of the securities offers periodic returns (as the case may be) and the principal amount on the maturity. These returns are then passed on to the mutual fund investors in the form of dividends or retained depending upon the nature of the schemes. The issuers of these securities could either be corporates or the Government who float their bonds to fund their major expansion programs. Example A debt fund say with a starting NAV of $.100 buys an 8.5% GOI security with a face value $.100, interest payment being annually, maturating after 5 yea$. The debt fund would earn $.8.50 annually and get back the principal of $. 100 at the end of 5 yea$. The Debt Fund spreads the $. 8.50 Of interest it earns annually over 365 days of the year i.e. it earns $. 0.0233 Per day.

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Debt Funds: How to select?

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If interest rate in the market declines and the Government comes with a fresh issue of 5 year bonds with coupon of 7.5% then the immediately the value of the old bonds of 8.5% will increase. This would happen due to the bond theorem that states that the price of a bond is inversely related to the interest rates. We are not going on to the technicals of bond pricing in this section. Say, the price of the 8.5% bonds will move from $ 100 to $ 105. If the 8.5% bonds are sold in the market, the new buyer will receive $. 8.50 Per year for 5 yea$ but will make loss of $. 5 on redemption of the principal at the maturity. The investor over 5 yea$ therefore earns $. 42.50 by way of interest and loses $ 5 on the principal amount invested giving a return of $. 37.50 over 5 yea$ which is equal to the new bonds.
New buying/Traded price (A) At maturity of 5 yea$: - Principal (B) Interest earned (C) Total gain (B-A)+C Old bond 105.00 100.00 42.50 37.50 New bond 100.00 100.00 37.50 37.50

As mentioned above, interest rates and bond prices are the two sides of a coin. To be more specific, bond prices falls when interest rates rises and they rises when interest rates falls. Therefore, bonds being the principal assets of a debt funds, their NAVs fluctuate in line with the bond prices. Risk and Return Bonds are often denoted as risk free investment. This is a perceived notion and may not always hold good. In fact, bonds carries risks in the form of credit risk, interest rate risk, prepayment risks, inflation risks, etc. Companies may go bankrupt or default on their debts for extended periods. On the other hand, certain bonds carry a call feature that may enable early redemption. This is known as prepayment risk. This happens when the firms issue high interest carrying bonds and market rate falls considerably after few yea$. So they call upon the older bonds and replace them with new low cost ones. Though, it is better than not being paid back at all, but the investor has to bear the brunt on account of opportunity cost. However, investor sometimes prefers callable bonds when they anticipate the interest rates to rise before the maturity. Again, increasing inflation in the economy all influence the investments. The constantly increasing prices, erodes the purchasing power of the money. And as a bond investment locks up the money for a long period, a rising inflation trend can have a corrosive effect. How to select a debt fund? A debt fund is the only option left to invest in income-generating instruments without any botheration of transaction costs, stamp duty or lack of liquidity. Moreover, most of the high yielding debt instruments are directly not available to the retail individual investor. Debt has the advantage of being much less risky compared to equities. Equities do carry more returns but the returns are uncertain and there always a possibility of capital getting eroded completely. So, if one is expecting a stream of steady and consistent returns, a debt fund is the ultimate option. In recent times, choice of debt funds, or income funds was never a concern for investor because mutual funds offered similar schemes, all of which invested in corporate debt and public sector undertakings, government bonds and other money market instruments. The choice was quite simple. If investor needs a fixed income, a regular income scheme is selected. If wealth accumulation is the objective, a scheme that lets savings grow is preferred. However there are some schemes that offer both regular income along with growth options, and investor could choose between

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Debt Funds: How to select?

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them. Today, the entire scenario is different. The World market is coming across rapid innovations that offer wide variety of schemes as in developed financial markets. Apart from the regular debt funds, and their income and growth options, there are also money market and liquid funds, as well as gilt funds to choose from. Among the different schemes available, monthly income plans, so called MIP, have won the investor trust in a very short time. Some investor relies on their broker or financial advisor for choosing the right as they don't have enough time and expertise to go about picking a fund. In fact, professional advices can be ignored while selecting a debt fund. If the investor is aware of their investments requirements, it's not that hard to select a fund. Let us discuss the different types of schemes available to the investor to choose from. Income schemes- These schemes aim to provide capital protection and steady income. Income schemes usually offer the best returns among those investing in various forms of debt. In addition to the standard income several schemes are now offering - dividend reinvestment. Here, the dividends that you might otherwise spend are reinvested in the fund, getting you more units. Money market schemes This fund allowed the investor to park their fund in the money market instrument like government securities, Treasury bill. Though the return on these securities are less compare to other instrument but these securities are assumed to be risk free and most liquid fund as they are sovereign paper of government. How to select a Right Fund Bonds are the investment of choice in the bearish markets. When the equity market turn bearish return normally drops. As per the survey the recent crash of stock market results drop in 50 per cent of the price of almost 40 percent actively traded stocks. In a panic situation of stock market and stable interest rate in the world , Active management of portfolio are likely to enhance portfolio returns and reduce risk .Asset allocation is critical for investor today, when interest rates may stabilize or even move up, as it was when interest rates where in a free fall. However, there will be a gradual rise in interest rates all over the world. But a comfortable liquidity condition, moderate inflation and integration of Indian capital markets with global capital markets will not allow domestic interest rates to spike. Any rise is likely to be gradual. If the interest rate goes up, the bond prices will adverse affect. As per the bond theorem the degree of fall depends on the maturity of the securities. Lower the maturity lower will the fall in price and vice versa. An active manager endeavour to invest more in short maturity securities, when rates are expected to move up and invest more in long maturities when rates are expected to go down. In the stable or higher interest scenario mutual fund have two options. They could increase the number of securities in the portfolio to decrease the duration. This would mean buying paper that mature earlier and then invest the proceeds at the prevailing interest rate in the market, which are higher. But the obvious problem is that interest on short term securities is less compared to long term. The second alternative is to go for riskier securities that give higher return. But in this case risk will increase substantially. What investor can do? Let us discuss in detail: Historical Performance: Debt fund investor should judge where the particular fund has performed well in the past. A track record of good returns can be reassuring, but is not a guarantee of future performance as the scenario has

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Debt Funds: How to select?

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been change and the fund which is performed well at the time when the interest rate was falling down may not be perform well in the stable or increasing interest rate scenario. But one can take the additional parameter as historical return of one year because in the accounting year 2003-2004 interest rates were almost constant it is stick to well-established funds, though. An established name has a reputation to keep and will generally work hard on your money. Consistency of performance is also easier to judge with funds that have been around a while. Attitude: Before investment another important thing is attitude of fund manager, transparencies and the quality of disclosure. With view to help the investor in selecting fund several Credit rating agencies has launched a product for grading the management and governance quality of mutual funds. Credit risk refers to the credit rating of the instruments that debt funds invest in. Typically, debt papers are rated according to their ability to return the principal and make timely interest payments. The higher the rating, the safer the instrument. Schemes can improve returns by investing in lower-rated paper, but they are riskier. So now investor can judge different types of risk associated with the fund Apart from that factor investor can consider the other factor also such as load size, and the maturity profile of the investments. Conclusion: The uncertainty in the stock market one aging lure the investor towards debt fund .Though the return on debt fund is low compare to equity fund but debt fund is still as safe instrument. About The Author
Sanjeev Kumar, ICFAI Hyderabad

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