Debt MFs are investors’ ally for fixed-income investments

Indians’ age-old romance with bank fixed deposits (FDs) appears to be souring in the backdrop of easing interest rates. The rate of interest offered by a one year FD1 is currently trending at 6.75% versus 9.00% five year ago. In addition, FDs are not very liquid and flexible.

On the other hand, debt mutual funds are gaining appeal precisely on these counts. They provide investors an opportunity to benefit from the broader debt market, based on their risk-return profile and investment horizon.

Of course, being a mutual fund product, investors can enjoy all the other benefits, too, such as professional management, access to a diversified portfolio, convenience, and liquidity. Read on to find out how debt funds can be investors’ ally for fixed income investments.

Debt funds invest in fixed income instruments across the debt market. Investors can choose from a wide universe of debt funds based on their risk-return profile. Here are the types of debt funds:

Liquid funds: These funds invest in debt market securities with maturity of less than 90 days and are a good option for investors who wish for returns higher than those of savings bank accounts with comparable liquidity. The recent introduction of instant redemption feature of up to Rs 50,000 from liquid funds is another plus in case you find yourself facing an unexpected cash crunch.

Ultra-short-term debt funds: These funds invest in debt securities which have a maturity of up to one year and are a good option for investors with an investment horizon of up to a year.

Fixed maturity plans (FMPs): These funds are closed-ended funds and invest in debt instruments having tenure equal to or less than the maturity of the fund. The tenure can be of different maturities, from one month to three years. As they lock in the investment at prevailing yields, they are less volatile to interest-rate changes. These funds are listed on the stock exchanges and the route can be used to liquidate in the interim period if required albeit at a discount due to paucity of trading on the exchanges.

Short-term debt funds: These funds invest in debt instruments having a short-to medium-term maturity of one year to five years. These funds can be invested for a horizon of one year to three years. As they are less sensitive to interest-rate movements, they are less risky than duration-based funds.

Long-term debt funds: Income and gilt funds invest in an underlying portfolio of long-term bonds and government securities, respectively. Typical investment horizon would be of over three years, which provides indexation benefits (explained later). Being high on duration, these funds are more sensitive to interest rate changes, benefitting during periods of fall in yield.

Stable performance and indexation benefit are the pros of these funds. Debt MFs have historically been able to generate stable returns across periods analysed. Returns have outdone inflation (around 7%1 historically), which is the biggest risk to real returns from fixed income instruments.

Additionally, they reduce the tax outgo when held for three years or more through the indexation benefit. Simply put, taxable returns from debt funds are reduced by inflation during the period to get the actual liability. In the above table, the long-term (10-year) return of 8.72% (Crisil-Amfi Income Fund performance index) would be reduced by inflation (7%), and tax would be paid on residual returns as against taxation on entire returns from FDs.

However, the flip side of debt fund includes interest rate, liquidity and credit risks. Debt funds do not guarantee returns, they shadow the underlying market (marked to market). Further, these funds are subject to interest rate, liquidity and credit risks based on the category invested in. Hence, investors must map their investments based on their risk appetite, and should conduct diligence on schemes before investing.

The writer is senior director, funds and fixed income, Crisil Research