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Debt Funds Simplified

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Debt Funds Simplified booklet with Outlook Money

Debt Funds Simplified booklet with Outlook Money

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  • 1. Debt funds simplified
  • 2. Copyright © Outlook Publishing (India) Private Limited, New Delhi. All Rights Reserved No part of this book may be reproduced, stored in a retrieval system or transmitted in any form or means electronic, mechanical, photocopying, recording or otherwise, without prior permission of Outlook Publishing (India) Private Limited. Printed and published by Maheshwer Peri on behalf of Outlook Publishing (India) Pvt. Ltd Editor: Udayan Ray. Published from Outlook Money, AB 5, 3rd Floor, Safdarjung Enclave, New Delhi-29 Outlook Money does not accept responsibility for any investment decision taken by readers on the basis of information provided herein. The objective is to keep readers better informed and help them decide for themselves. Project Editor Kundan Kishore Copy Editor Shinjini Ganguli Art Director Manojit Datta Design Bhoomesh Dutt Sharma; Saji CS Cover Design Bhoomesh Dutt Sharma [1] Introduction.........................................................................................2 What is debt fund...............................................................................2 How debt funds work ........................................................................3 Gilt funds, short- and long-term funds............................................5 How is it different from other MFs...................................................9 Why invest in debt MFs..................................................................10 Watch out.......................................................................................... 11 Who should invest in debt MFs...................................................... 11 How to pick the right debt fund.....................................................12 Debt fund investment options........................................................16 Using debt funds for STP and SWP..............................................18 Using debt funds for specific goals................................................19 contents July 2013 Debt Funds Simplified
  • 3. [2] I t’s time to bid goodbye to traditional fixed income prod- ucts and, instead, embrace debt funds to achieve your financial goals. If you prefer steady returns and low vola- tility, debt funds can take you a long way. WHAT IS DEBT FUND A debt fund is a mutual fund scheme that invests in fixed in- come instruments, such as bonds, corporate debt securities and money market instruments, etc. that offer capital ap- preciation. It is ideal for investors who want regular income, but are risk-averse. Debt funds are less volatile and, hence, are less risky than equity funds. They invest in short- and long-term corporate and government bonds. simplified Debt funds If you want to avoid the choppy markets and the erratic returns, consider investing in debt funds
  • 4. HOW debt funds WORK Debt funds invest in either listed or unlisted debt instru- ments, such as bonds or corporate debt securities at a cer- tain price and later sell them at a margin. The difference be- tween the cost and sale price accounts for the appreciation or depreciation in the fund’s net asset value (NAV). A debt scheme’s NAV depends on the interest rates of its underlying assets and also on any upgrade or downgrade in the credit rating of its holdings. Market prices of debt se- [3] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 5. curities change with movements in interest rates. Let’s assume, your debt fund owns a security that yields 10 per cent interest. If the interest rate in the economy falls, new instruments that hit the market would offer this lower rate. To match this lower rate, there would be an increase in your fund’s instrument prices as they have a higher coupon rate. As a result of the increase in the debt instrument’s value, your fund’s NAV, too, would increase. In terms of return, debt funds that earn regular interest from the fixed income paper during the fund’s tenure are similar to bank fixed deposits that earn in- terest. This income gets added to a debt fund on a daily basis. If the interest comes, say, once a year, it is divided by 365 and the debt fund’s NAV goes up daily by this small amount. [4]
  • 6. GILT FUNDS, SHORT- AND LONG-TERM DEBT FUNDS Like in any other mutual fund scheme category, there are various types of schemes in the debt fund category too. They are classified on the basis of the type of instruments they invest in and the tenure of the instruments in the portfolio. Some generic types of debt funds are explained below: Income funds. They invest primarily in debt instruments of various maturities in line with the objective of the funds and any remaining funds in short-term instruments such as money market instruments. These funds generally invest in instruments with medium- to long-term maturities. Short-term funds. Short-tenure debt funds primarily in- vest in debt instruments with shorter maturity or duration. These primarily consist of debt and money market instru- ments and government securities. The investment horizon of these funds is longer than those of liquid funds, but short- er than those of medium-term income funds. Floating rate funds (FRF). The objective of FRFs is to offer steady returns to investors in line with the prevailing mar- ket interest rates. While income funds invest in fixed income debt instruments such as bonds, debentures and govern- ment securities, FRFs are a variant of income funds with the primary aim of minimising the volatility of investment returns that is usually associated with an income fund. FRFs invest primarily in instruments that offer floating in- [5] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 7. [6] terest rates. Floating rate securities are generally linked to the Mumbai Inter-Bank Offer Rate (MIBOR), i.e., the bench- mark rate for debt instruments. The interest rate is reset pe- riodically based on the interest rate movement. Liquid funds. As the name suggests, liquid funds invest pre- dominantly in highly liquid money market instruments and provide liquidity.They invest in very short-term instruments such as treasury bills and the inter-bank call money market, commercial paper (CP) and certificates of deposit (CD) that have residual maturities of up to 91 days. Gilt funds. The word ‘gilt’ implies government securities. A gilt fund invests in government securities of various tenures issued by central and state governments. These funds gener- ally do not have the risk of default since the issuer of the instruments is the government. They offer both short-term and long-term plans. Short-term plans invest in securities issued by the central government and/or a state government with short-to-medium-term residual maturities. Long-term plans invest in securities issued by the central government and/or a state government with medium-to-long-term ma- turities. Gilt funds have a high degree of interest rate risk, depending on their maturity profile.The longer the maturity profiles of the instruments, the higher the interest rate risk. Interest rate risk implies that there is an effect on the market price of debt instruments when interest rates increase and
  • 8. decrease. Market prices of debt instruments rise when inter- est rates fall and vice-versa. Interval funds. These invest in debt and money market in- struments, and government securities having residual ma- turity until the beginning of specified transaction periods (STPs). Interval funds have characteristics of both open- ended and closed-end funds. In other words, these funds are open for subscription and redemption during the STPs. Thereafter, units of these funds are available for trading on stock exchanges. Multiple yield funds. Multiple yield funds (MYFs) are hybrid [7] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 9. debt-oriented funds that invest predominantly in debt in- struments and to some extent in dividend-yielding equities. The debt instruments assist in generating returns with min- imum risk and equities assist in long-term capital apprecia- tion. MYFs invest predominantly in debt and money market instruments of short-to-medium-term residual maturities. Dynamic bond funds. DBFs invest in debt securities of dif- ferent maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the inter- est rate view of the fund managers. Such funds give the fund manager the flexibility to invest in short- or longer-term instruments based on his view on the interest rate movement. DBFs follow an active portfolio duration management strategy by keeping a close watch on various domestic and global macroeconomic variables and interest rate outlook. Some other MF schemes, such as fixed maturity plans (FMPs) which invest in debt instruments with a specific date of maturity equal to the maturity date of the scheme, also enjoy the status of debt funds. However, it is closed-end in nature. Other hybrid schemes that invest in a combination of debt and equity, such as monthly income plans (MIPs) and capital protection oriented funds, also form a part of debt funds. By investing in all these funds, investors can take all the advantages of debt funds. [8]
  • 10. [9] HOW IS IT DIFFERENT FROM OTHER Mutual fund SCHEMES In terms of operation, debt funds are not entirely differ- ent from other mutual fund schemes. However, in terms of safety, they score higher than equity mutual funds. For in- stance, when the market falls, the NAVs of your equity funds fall sharply, whereas in case of debt funds, the fall is not as an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 11. sharp. Having said that, debt funds can offer only moder- ate returns, while equity funds, which are highly risky, offer high returns over longer time horizon. WHY INVEST IN DEBT MUTUAL FUNDS A few major advantages of investing in debt funds are low cost structure, stable returns, high liquidity and reasonable safety. Debt funds also score on post-tax return. Dividends from debt funds are exempt from tax in the hands of inves- tors. The fund, however, has to pay a dividend distribution [10]
  • 12. tax of 28.325 per cent in case of individuals or Hindu un- divided families. While long-term capital gains from debt funds are taxed at 10 per cent without indexation and 20 per cent with indexation, short-term capital gains taxes are levied according to the income-tax bracket one belongs to. Thus, debt funds can be a good alternative to investors for achieving their financial goals if they do not intend to bear equity risk. WATCH OUT Choose the appropriate option in debt funds depending on your tax bracket as dividend is subject to dividend distribu- tion tax, which decreases returns.You can opt for a dividend reinvestment option for better post-tax returns if you are in the highest tax bracket. Else, go for the growth option. WHO SHOULD INVEST IN DEBT MUTUAL FUNDS There’s no fixed rule as to who should invest in debt funds. It depends on the requirement of investors. Different types of in- vestors invest in different types of debt funds. For instance, if some- one wants to park his emergency funds, he can go for liquid funds. As a thumb rule, 3-6 month’s [11] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 13. household expenses can be one’s emergency fund depend- ing on the age. Roughly the amount that gives you the con- fidence to combat emergencies in your household should be enough. Anything more can actually affect your investment portfolio. Those in their 20s and 30s might need more, so garner funds for about six months’ expenses, whereas those nearing retirement might not need much as they would have built up their reserves. The amount you save for an emer- gency depends ultimately on what makes you comfortable. If you are the risk-averse type, then you might prefer a large fund of, say, a year’s salary. If, however, you are the living- on-the-edge type, then six months’ salary might suffice. For those planning to buy a home after 2-3 years, investing in a combination of both long- and short-term debt funds might be a good idea. Also, a debt fund can be used in the overall portfolio for diversification across asset classes. Debt funds can also be used for portfolio derisking when you are nearing your financial goals. HOW TO PICK THE RIGHT DEBT FUND Remember, it is the asset allocation (government securities, corporate debt and marketable securities) that largely deter- mines how a debt fund’s NAV will move. A close look at a fund’s portfolio composition will give you an idea of the ex- pected returns, risks and liquidity. So, when picking a fund, [12]
  • 14. watch out for a few things. One, check the average maturity of the fund’s portfolio as this has a bearing on your returns. The lower the average maturity period, the lower the fund’s volatility and your re- turns. On the other hand, a fund with a long maturity pe- riod is likely to be more volatile, but the returns are likely to be better. [13] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 15. Two, make sure the fund’s portfolio is reasonably liquid. A large percentage of corporate debt in the portfolio does not bode well in the short term, as it is relatively less liquid. If the fund faces redemption pressure, it would be forced to sell these securities at a discount, lowering the NAV. Also, be wary of funds that hold a lot of unrated and unlisted debt. Three, avoid schemes with small corpuses. That’s because funds don’t disclose if there are any investor who owns a [14]
  • 16. [15] substantial chunk of outstanding units. If there are such investors and they decide to redeem their holdings, the fund could be forced to sell holdings below the market rates. Four, the best tool to capture the interest rate sensitivity of a debt fund is modified duration. It tells you how much the price of a bond would move if interest rates move up or down by 1 per cent. The higher the modified duration, the greater will be the impact of an interest rate change. Mutual funds give you access to all the information in their offer documents and other periodic disclosures for you to make an informed decision. It is then up to you to take the investment decision and sign the form, or channel the money to suit your financial needs. Also, you should understand how interest rate movements, credit ratings and liquidity affect a debt fund’s performance. Theoretically, if interest rates rise, the NAV of a debt fund should fall. That’s because bond prices move in the opposite direction as interest rates. A fall in bond prices leads to a de- cline in a fund’s NAV. The opposite would happen if interest rates fell. Of course, in an imperfect and illiquid market like ours, this might not happen to the entire extent. Moreover, if some bonds held by your debt fund are upgraded, their prices would rise, leading to a drop in yields. That would, of course, increase your fund’s NAV. So, be prepared for fluc- tuations in your fund’s NAV. Even gilt funds (which invest only in government securities) that are advertised as the saf- an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 17. est available investments, can witness sharp fluctuations in their NAVs. That’s because prices of government securities are a function of various economic factors, including inter- est rates, macroeconomic data and liquidity in the banking system. When these change, so do the gilt fund’s NAV. DEBT FUND INVESTMENT OPTIONS Offline agent. Your neighborhood distributor helps you choose a mutual fund scheme, brings you the forms and, [16]
  • 18. perhaps, even fills them up for you. He also helps you submit these to the respective mutual funds besides fetching your account statements directly from your mutual fund. But for all these services you are charged a transaction fee of `100 (`150 for the first-time investor) for an investment of `10,000 or more. Online agent. If you prefer transacting from the comfort of your home or office, you can reach out to various online brokerages. These work with three types of accounts—In- ternet trading account, demat account and savings bank account with a partner bank. For a price, online brokerages enable transactions in several instruments, such as shares and gold, besides mutual funds. Direct application to fund house. If you wish to apply to a mutual fund directly, submit your application form along with necessary documents at the mutual fund’s office or at any point of acceptance (PoA) across the country (a list is available in your scheme’s offer documents). Note that di- rect application forms should be collected only from official centres. Make sure the box for agent code on the top of your application is not left blank. Write ‘Direct’ in it when you submit the form to your mutual fund. Transaction charges of `100 or `150, as mentioned above, are not imposed on direct applications. Fund’s website. Another way for direct investment is through your mutual fund’s website. As this option is only [17] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 19. open to existing investors, you must submit physical forms at least once to open your account with a mutual fund. Once you get your account statement, download the online reg- istration form, mention your folio number in it and submit the same to the mutual fund. Your mutual fund will then give you a code that you can use to log into your fund’s web- site and transact subsequently. USING DEBT FUNDS FOR STP AND SWP Debt funds also allow you to take advantage of investing in [18]
  • 20. equity market along with growth on your principal amount through systematic transfer plan (STP). With an STP, you can transfer amounts in parts/tranches from one mutual fund scheme to another, within the same fund house at reg- ular intervals. Such a transfer averages the cost of purchase, mitigating some market-related risks. Typically, an investor first parks his funds in a liquid or a floating-rate debt fund and then transfers them via STP to the scheme (usually eq- uity or balanced) of his choice at regular intervals. Systematic withdrawal plan (SWP) is a payment option in a mutual fund that lets you redeem units worth a pre- specified amount at a specific intervals (monthly, quarterly, half-yearly or annually). This is suitable for the investors who desire periodic income. USING DEBT FUNDS FOR SPECIFIC GOALS Choosing funds for children’s education. When it comes to taking the mutual fund route for your children’s future, the basic rules of the game are essentially the same as that for any long-term goal. But here, merely investing will not work. You need to be cautious about the risk management of your corpus, especially when your child is close to going for his higher studies. Along with investing, making the money available at a time when your child needs it is equally important. So, here debt funds play a vital role. With time on your side, investing in equity has many ad- [19] an investor education and awareness initiative by hdfc mutual fund Debt Funds Simplified
  • 21. vantages. But you need to keep a close eye on the market once you are less than three years away from your goal. One needs to derisk the portfolio when you are nearing your tar- gets to ensure that the gains you have earned are not wiped out. In other words, as you near your target, start shifting from equity to debt so as to secure your gains. When moving away from high-risk options, you could choose to move into liquid and short-term debt funds or slightly riskier funds in the debt space, such as bond and gilt funds, depending on the interest rate scenario prevailing at that time. For instance, if the interest rates are falling, [20]
  • 22. an investor education and awareness initiative by hdfc mutual fund short- to long-term bond and gilt funds would bode well. But if interest rates remain flat or move upwards, stick to liquid funds; they are safer than the rest of the debt schemes, if not the safest of all financial instruments, and they would still earn you more than your savings bank account. The ideal way to build an adequate corpus for your child’s future is to go step by step. The sooner you start, the better. Of course, you also need to stop along the way occasionally to make sure things are going as planned. The closer you get to your destination, the more careful you need to be that you are not taking a wrong turn. Role of debt fund in retirement portfolio. As you age, light- en your equity funds holdings marginally; the aggressive in- vestor should cut equity in his portfolio from 80 per cent to 70 per cent, and the conservative investor from 60 per cent to 40 per cent. With about 15 years away from retirement, you should start playing steady and balance your exposure to debt and equity. For instance, the conservative investor may choose a 10-20 per cent higher debt allocation. On the debt side, you may look at floating-rate funds and fixed- maturity plans. Balanced funds are another option for the semi-aggressive investor to strike a debt-equity mix. Strategy. Follow the life stage approach to investing while saving through mutual funds for retirement needs. As you age, keep balancing the allocation between equity and debt. With around 10 years away from your retirement, your pri- [21] Debt Funds Simplified
  • 23. ority should be to ensure the safety of your accumulated wealth. Plan out the derisking strategy and wait for an op- portune time to migrate your money from volatile equity to safer debt. By the time you are 1-2 years away from retire- ment, a large portion should have been moved away from equity into debt funds. Acquiring a home. Investing in mutual funds not just helps in creation of wealth but also helps in creating assets. They play an important role in helping one build the biggest asset of life—a home of your own. Paying the equated monthly instalments (EMIs) has come reasonably within the reach for most families, especially when both partners work. However, accumulating a big lump sum to pay the downpayment on the house remains the biggest obstacle. This is where mutual fund schemes come in handy. All those who live on rent constantly won- der why they should be throwing their hard-earned money out as expenses, when they could use it to buy a house and create an asset. That is more so now, when property prices have, perhaps, settled down and when home loans are eas- ily available as housing finance companies are offering easy loans to customers. If you are contemplating buying a house in 2-3 years, mutual fund schemes can help you accumulate the money, especially the downpayment for the loan. How they help. Generating funds from friends, relatives or [22]
  • 24. pawning gold might not be the best ways to arrange the money. Plan early to avoid depending on such sources as far as possible. If you feel that your personal circumstances are right for buying a home, start by creating a savings plan for your downpayment. Get an idea of the purchase price and the EMI payments that you can afford. Estimate what you’ll need for margin money, which is usually 20 per cent of the home price. Thereafter, calculate how much you must save every month. Where to invest. If the time horizon is less than a year or an investor education and awareness initiative by hdfc mutual fund [23] Debt Funds Simplified
  • 25. just a year away, it is better to stash funds in a money-market or liquid fund. The vola- tility in these funds is the least as exposure to equities is non-exis- tent. The idea is to pre- serve the capital and not take undue risks with the savings. Choose at least two debt funds for diver- sification’s sake and start saving through the systematic investment plan (SIP) process. Ideally, keep the portfolio tilted towards debt even if you are taking a bit of risk. Strategise your moves. Remember, even debt funds suffer from interest rate risk. So, ensure that you shift to less vola- tile debt funds, such as short-term debt funds, at least two years before reaching your goal. With just one year away from your goal, shift your savings completely into a liquid fund.Your small savings every month might not cramp your household budget, but they will still create a lump sum big enough to meet your downpayment needs for a home. [24]
  • 26. DISCLAIMER MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY. As part of its Investor Education and Awareness Initiative, HDFC Mutual Fund has sponsored this booklet. The contents of this booklet, views, opinions and recommendations are of the publication and do not necessarily state or reflect views of HDFC Mutual Fund. HDFC Mutual Fund does not accept any liability arising out of the use of this information.
  • 27. s