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RBI rate cut: Best debt mutual funds across categories. Find out which one suits you

There are a variety of debt mutual fund options, each suited for the needs of different investors. You can use debt funds to save for your child’s annual education expenses. Or save up enough to pay the down payment of your house next year.

, ET Bureau|
Last Updated: Mar 30, 2020, 09.33 AM IST
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The steep rate cut by RBI has boosted debt funds.
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The rate cut by the RBI led to a steep fall in bond yields on Friday. The benchmark 10-year bond yield dropped to 6.07% compared to the 6.7% it has averaged in the past one year. This in turn gave a big boost to the NAVs of debt funds, especially schemes that have lined their portfolios with long term bonds. When rates go down, existing bonds with higher coupon rates become more attractive. Long-term bonds benefit the most in such situations.

Does that mean long-term bond funds will outperform now? Not really. Experts believe that after the 75 basis point cut, there is very little scope for bond yields to go down further. In fact, Bloomberg economists expect 10-year yields to average at 6.65% 2020-21. So, long-term bond funds could actually lose money as bond yields rise in the coming months.

The interest rate changes are not the only problem. While the decline in bond yields in the past one year have pushed up returns for most funds, the unexpected downgrades and defaults have also wiped out gains for some schemes.

There are a variety of options, each suited for the needs of different investors. You can use debt funds to save for your child’s annual education expenses. Or save up enough to pay the down-payment of your house next year. You could be wanting to invest for a very short tenure like 10-15 days. Or you could be seeking regular income from a safe option in retirement. Whatever you need, there is a debt fund for that purpose.

Our cover story this week looks at the various categories of debt mutual funds. It looks under the hood of these categories to know where they invest, the risks they carry and the kind of returns to expect from these funds.

1. Accrual Funds
Accrual funds invest in securities with short to medium-term maturity. These funds follow a buy and hold strategy to deliver returns higher than those of fixed deposits. In other words, the funds invest in securities or bonds with a higher coupon and hold them till maturity. The interest earned on the securities “accrues” to the fund, which explains their category name. Such funds are best suited for low to medium risk profile investors.

Indians love to invest in fixed income options, but this love does not extend to debt funds. Despite the advantages they offer, very few people know about debt funds and even fewer invest in them.

CORPORATE BOND FUNDS

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Data source: ValueResearch. Returns data based on 23 March 2020 NAVs. All other data for February 2020.

Corporate bond funds invest 80% of their corpus in corporate bonds or non-convertible debentures. The investments are guided by the ratings assigned to bonds by rating agencies. Typically, high ratings are given to companies and institutions that are financially strong and have a good record of paying lenders on time. High credit rating implies lower probability of default and therefore, such funds are classified as low-risk funds.

These funds are ideal for an investment horizon of 2-3 years. There are 19 corporate bond funds managing a total corpus of Rs 85,170 crore. This corpus has grown 65% in the past one year. In February 2020, over 75% of the total corpus of these funds was invested in ‘AAA’ rated securities and nearly 13% in the sovereign government bonds. Over 82% of the funds have an average maturity of less than four years with an average expense ratio of 0.73%.

CREDIT RISK FUNDS

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Data source: ValueResearch. Returns data based on 23 March 2020 NAVs. All other data for February 2020.

As their category name suggests, these funds take a bit of risk. They invest at least 65% of their money in securities with ratings lower than AA-. Given that low rated securities are prone to the risk of default, borrowers charge a higher rate as compensation. These funds benefit from the higher coupon rate and any possible improvement in the credit rating of a bond. However, these funds carry a significant default risk.

The risk gets compounded if the fund is holding too many securities issued by the same group. Investors looking for steady income and with low-risk appetite should stay away from these funds. Even those with moderate to high-risk appetite should only look for large-sized funds that do not concentrate investments in a single group. There are 31 credit risk funds, with 24.2% of the corpus in ‘AA’ rated securities, 18.8% in ‘AAA’, and ‘10.98% in AA-’ rated bonds.

2. Duration Funds
These funds focus on the duration of the fund and earn returns from the capital appreciation and coupon income. They benefit when the interest rates are expected to fall. Longer the duration, the more volatile is the fund and vice-versa. Sebi has classified duration funds based on the Macaulay Duration.

What is Macaulay Duration?
Expressed in number of years, this measures the weighted average term to maturity of the cash flows from the bond. In other words, it measures the time in which an investor will receive the amount invested in bonds through interest payments and repayment of principal. The calculation takes into account the bond’s price, maturity, coupon, and yield to maturity. Keeping other factors constant, an increase in maturity leads to an increase in duration and vice-versa. It is a parameter used by debt fund managers to create portfolios depending on the level of the interest rates.

Why it matters
It helps to determine the risk profile of a fund relative to the changes in the interest rates. Long duration funds are more sensitive to changes in interest rates compared to short-duration funds. It helps investors to choose the right fund depending on their investment horizon.

ULTRA SHORT DURATION FUNDS

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Ultra short-duration funds invest in securities with a portfolio Macaulay duration of 3-6 months. This makes them less susceptible to volatility and ideal for investment for a few weeks or few months. These funds generate returns slightly higher than savings bank account. There were 24 ultra-short duration funds with an average YTM of 6.2% in February 2020. The corporate debt (44.6%), certificates of deposit (25.3%), and commercial papers (16%) constitute the top 3 assets of these funds in terms of the percentage of the AUM invested.

LOW DURATION FUNDS

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Low duration funds invest in money market and short term debt securities with a portfolio Macaulay duration of 6-12 months. They are suitable for investors with low to moderate risk profile who want to park money for the short term and earn more than what liquid funds offer. These funds invest a portion of their assets in securities with ratings less than ‘AA’ which enables them to generate returns higher than the liquid funds. Most of the 22 low-duration funds had a YTM less than the average YTM of 6.78% in February 2020. The average expense ratio is 0.81%.

SHORT DURATION FUNDS

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These funds invest in securities with a portfolio Macaulay duration of 1-3 years. They hold bonds of good quality companies with strong cash flows. Those looking for a better tax-adjusted returns can consider these. These funds are also useful for saving for short term goals. There are around 30 short duration funds. Over 58% of their AUM was invested in AAA-rated securities in February 2020. The average YTM of these funds was 6.7%.

MEDIUM DURATION FUNDS

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These funds invest in securities with a Macaulay duration of 3-4 years and are relatively more sensitive to the interest rate cycles. These funds are suitable when the interest rates are likely to remain constant or expected to decline in the future. The funds in this category have an average YTM of 8.7% with an average expense ratio of 1.4% in February 2020.

MEDIUM TO LONG DURATION FUNDS

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The investment portfolios of these funds have Macaulay duration between 4 and 7 years. Such longer duration makes them extremely sensitive to the changes in interest rates. These funds are advisable for an investment period of more than 5 years. Thirteen funds in the category have an average portfolio maturity of 6.8 years as of February 2020 with an average YTM of 7%.

LONG DURATION FUNDS

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These funds have a portfolio Macaulay duration of more than 7 years and benefit when interest rates fall. Investors with a high risk appetite and long horizon should consider them. Past one year returns have been the highest among all debt fund categories due to falling rates.

DYNAMIC BOND FUNDS

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These funds dynamically manage the duration by investing in securities of different durations depending on the fund manager’s assessment of the future interest rate movements. These are suitable for investors who want to benefit from the changing level of interest rates. However, a pause in the interest rate by the central bank could significantly affect their performance. 37 funds in this category have invested over 93% of their total corpus into corporate debt and government securities with an average YTM of 6.9% as of February 2020.

GILT FUNDS WITH 10-YEAR CONSTANT DURATION

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These funds invest a minimum of 80% of their corpus into government securities and ensure that the Macaulay duration of the portfolio is equal to 10 years. These funds are free from credit risk and are meant for risk-averse investors. As RBI has reduced the repo rate by a cumulative of 135 basis points since February 2019, these funds along with other gilt funds have generated double digit returns in the past one year.

Other debt fund categories
LIQUID FUNDS

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These funds invest in money market securities with maturity up to 91 days. Government securities, treasury bills, and call money are some of the avenues where liquid funds invest. These are suitable for parking money for the short term and has a near-zero risk of loss. These funds are considered safest among short term debt funds due to their low lending duration and have a minimal interest rate risk and credit risk. These funds have an average YTM of 5.4%.

BANKING AND PSU FUNDS

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These funds invest at least 80% of their corpus in bonds issued by banks and PSUs. The high credit ratings of PSUs make these funds very secure from default risk. But these funds are still prone to interest rate risks. They offer a strong alternative to the bank fixed deposits and offer the benefits of higher returns and tax efficiency in the form of long-term capital gains and indexation benefits if held for more than three years. The average YTM offered by these funds is 6.6% which is better than current 5.9% rate offered by SBI on its fixed deposits.

FLOATING RATE FUNDS
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These funds invest at least 65% of their corpus in securities with varying interest rates. Such securities tend to vary their coupon rate with the changes in the interest rates and thereby minimise the interest rate risk. When the interest rates are rising, such funds minimise the capital erosion. These funds are not so popular among investors when the interest rates are expected to fall. Floating rate funds can invest in both short and long maturity papers. In February, the average YTM of these funds was 6.5% with the majority of the corpus invested in corporate debt (57.4%) followed by certificate of deposits (17.3%), and government securities (15.6%).

Also read: Arbitrage mutual funds: Equity funds that work like debt funds

Liquidity and ease
Let us start by enumerating the several advantages that debt funds offer investors. For one, they are almost as liquid as a fixed deposit but without any cost. When you redeem your funds, the money is in your bank the next day. Also,a premature withdrawal from a fixed deposits attracts a penalty whereas the exit loads of debt funds are fairly lenient. Many short-term debt funds have no exit loads at all. Even liquid funds charge a maximum exit load of 0.007% if redeemed before one day. That’s Rs 7 on an investment of Rs 1 lakh, and comes down to nil after seven days.

With the fixed deposit rates declining, short-term debt funds provide a good alternative avenue to invest for a short to medium time period.

Tax advantage
The other major benefit is the tax efficiency. Interest from fixed deposits and other small saving schemes are added to the income of the investor and taxed at the applicable tax slab. If a fixed deposit is offering 7%, the post-tax return in the 30% tax slab will be less than 5%.

On the other hand, debt funds are treated as capital assets. Though short-term gains are also added to the income of the investor and taxed at normal rates, the gains are trated as long-term gains if the holding period exceeds three years. Long-term capital gains from debt funds are taxed at 20% after indexation. Indexation takes into account the inflation during the holding period and accordingly adjusts the acquisition price upwards to reduce the tax.

What’s more, if the holding period is spread across four financial years, the investor gets the benefit of four years’ indexation. Therefore, debt funds prove effective for those in the highest tax slabs. This is also why there is often a rush to invest in such debt instruments at the end of the financial year.

However, that window is almost closed now. The government has extended the last date of tax saving investments to 30 June, but it is not clear if securities purchased till that date will be deemed to have been purchased during the financial year 2019-20.

Systematic convenience
If equity fund investors benefit from systematic investments, debt fund investors benefit from systematic withdrawal plans (SWPs) and systematic transfer plans (STPs). Retirees looking for a regular income can invest in a debt fund and start SWPs. As the name suggests, a fixed amount is redeemed from the investment every month or quarter. The SWP arrangement is a very tax efficient because the entire amount withdrawn is not taxed. Only the gain is taxed, which can be very minimal. Later, after the investment is more than three years old, the tax comes down even further due to the lower tax rate and indexation benefit.

The SWP option has become more attractive now that dividends will be taxed. Moreover, dividends are dependent on the scheme’s performance while SWPs are customised to the investor’s requirements.

Investors can also use the STP option to invest in equity funds through debt funds. Experts recommend that monthly SIPs are the best way to invest in equity funds. If you have a large sum to invest, don’t let it idle in the bank to earn a paltry 3-4%. Instead, put it in a debt fund and then start a STP into an equity fund. Under this, a fixed sum will gradually get transferred to the equity fund. It offers investment flexibility and enables investors to earn higher returns compared to the savings bank account.

However, STP will be ineffective if the debt fund loses money and therefore, STP should be implemented in funds that have a lower credit risk.

Surprised? Don’t be. In recent months, there have been several incidents of defaults and downgrades which led to steep declines in some debt funds. To safeguard the interests of investors, Sebi has allowed the practice of side pocketing. Under this, a fund can segregate the toxic securities and keep them in a separate portfolio. If the bond issuer pays back the interest and principal, investors get their money back. This means an investor can exit these funds without relinquishing his right to reclaim his losses at a later date.

Also read: Debt mutual funds can be risky. Here's how to safeguard yourself

Also Read

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Is it a good time to invest in bluechip mutual funds?

Best gilt mutual funds to invest in 2020

What are ELSS or tax saving mutual fund schemes?

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