Should I Remain Invested In Debt Funds?

Published On: 01-Jun-2020

It is said, “one should not keep all his eggs in one basket.” While the equity markets have continued to stay volatile, the investors have started to focus on diversification across different asset classes. To further support the benefits of investing across various asset classes, CRISIL 10-year Gilt Index generated 14.55% returns during the year 2019-20, as against negative returns of 24.85% generated by Nifty 50 Total Return Index.  Source: NSE India & Crisil.com

 

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Debt mutual fund schemes invest primarily in fixed income securities, which helps the investors in terms of income stability, lower volatility as well as reasonable returns. Debt funds may generate income through the following three modes:

Accrual Income

This represents the accrual of interest income on debt securities in which the fund has invested its portfolio. Such accrual gets factored in the valuation and NAV (Net Asset Value) on a daily basis. Such accrual income is generally gauged through the Yield to Maturity (YTM) of the fund.

Appreciation due to Changes in Interest Rates 

The changes in the market interest rates may make existing security issued at higher coupon rates favourable in the markets. As such, the debt securities command a premium, which reflects in the NAV of the scheme as well. This helps to push the returns higher for the scheme. Further, the impact of interest rate changes on the portfolio valuation also depends upon the residual maturity of the debt securities. The longer the duration, the higher the valuation implications for changes in the interest rates. 

Potential Rating Upgrades

The valuation of the debt securities tends to factor the credit spreads as applicable to the issuer entity. If the credit risk for the issuer entity reduces, leading to rating upgrades, the credit spreads also moderate, leading to capital appreciation in the valuation of debt securities. 

Risk Mitigation in Debt Funds

While the debt securities continue to stay exposed to credit risk and interest rate risk, such risks are mitigated through the use of risk mitigation strategies. that generally include the following:

  1. Adequate Research – Professional fund managers make investment decisions based on the management interactions and adequate research by the team of research analysts helping the fund managers. 

  2. Investment Bucketing – Debt funds further mitigate the concentration risk by specifying the internal limits for exposure to a single issuer entity, group entities as well as sectors There are SEBI prescribed limits for extend of debt exposure for single issuer, group, sector etc.

Granular Investor Liability – Just like the diversification is crucial on the investment side. It is equally important to stay diversified across the liability side as well. A concentrated investor or distributor profile carries the potential of stressing the scheme liquidity, and thus, debt funds set internal limits for investors as well as distributors’ exposure.  

Is it good to invest in debt funds?

Considering the ongoing uncertainty around the Covid-19 pandemic outbreak and its economic impact, the credit spreads across the credit ratings continue to stay elevated. The overall interest rates have not moderated, reflecting a higher risk perception by the investors even when the Reserve Bank of India (RBI) has announced healthy rate cuts. As such, the high yields provide an opportunity for the investors to generate better returns over the long term, basis the accrual strategy itself. 

To further cushion the liquidity for the mutual fund industry, RBI has also recently granted an additional line of credits to banks to lend specifically to Mutual Funds for an amount up to Rs. 50,000 crores amidst reduced trading activity in the capital markets. As the economic activities restart, the credit risk perception will likely moderate across the sectors. It can be expected to lower the credit spreads prevailing in the market, thereby topping up the returns for the debt fund investors. 

The debt fund investors may also consider the impact of taxation on the redemption, just in case they are planning to redeem their investments now. Debt funds provide tax efficiency for the units held for 36 months or more, as it provides indexation benefit for long term capital gains on debt funds. In case one plans to redeem the investments now and invest later in debt funds, the holding period of mutual fund investments needs to start again from the date of new investment.

As such, one may continue to stay invested in debt funds to benefit from the currently elevated yields despite healthy returns generated by debt during the last fiscal. 

Note: The tax provisions, as mentioned in the article, are for illustrative purposes only, and are updated as per the Union Budget 2020 passed by the Parliament. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.