Debt oriented funds are those which primarily invest in fixed income securities like Treasury Bills, Government Securities, Money Market Instruments, Corporate Bonds, etc. The returns arise from interest accrual and capital appreciation of these securities.The fund can hold short or long term securities, or a basket of securities with different tenures. They have lower returns than equity funds, but generate more stable returns.

Debt funds are often considered risk-free, but that is far from the truth. Since equity funds are market linked, they are more volatile than debt funds. However, returns on debt funds are also volatile, based on the investment strategy of the investor. Holding debt fund units is different from holding a debt instrument till maturity. In the latter case, the investor is not affected by the change in interest rates, and the price of the instrument as he does not look for selling it in the secondary market. But in case of debt fund, where different instruments of varying maturities are held, active management requires buying and selling in the secondary market at the market price of the instruments. This determines the price of the NAV of the fund. Debt funds are less volatile than equity funds, but are volatile nonetheless. Some of the risks associated with debt funds are as follows:

Interest rate risk:

This refers to a change in the price of a debt security due to a change in interest rates. The price of the security is directly impacted by interest rate risk. This affect the value of the fund. For example, in case of a rising interest rate scenario, funds holding shorter maturity instruments will do well; whereas in case of a falling interest rate scenario funds holding a longer maturity instruments will perform well. Interest rate risk increases with longer duration funds, as short term funds can liquidate their instruments and invest in fresh instruments when the interest rates increase.

Credit risk

Credit risk refers to the risk associated with the repayment ability of the issuer of the instrument. Government bonds therefore do not carry any credit risk. It takes into account whether the issuer is able to make interest payments on time as well as the maturity value when due. Defaulting by the issuer brings down the credit rating of his instruments, causing its price to fall. This will impact the NAV of the fund holding the instrument.

Liquidity risk

Some funds may hold securities that are not easily sold in the secondary market. If the fund holds such securities, the lack of liquidity may affect the fund value.Generally, government securities and money market instruments are highly liquid. Corporate bonds are less liquid, and the ones with a lower credit rating are even less liquid. Therefore, funds holding such illiquid bonds face liquidity risk. In case of downturn, these bonds may not be transferable easily, and may have to be sold at a discount, significantly affecting the value of the fund holding it.

Types of Debt Funds

• Liquid Funds: They invest in money market instruments that are highly liquid. Liquid fund is a good option for corporate and institutional investors as well as individuals to park surplus funds for a period of as short as a day.
• UltraShort-Term Funds: Also known as Liquid Plus Funds, these invest in securities that have a maturity period of less than one year. They are apt for investors willing to take slightly higher risk for a short term surplus available for 1-9 months.
• Floating Rate Funds: These funds invest in floating rate securities and are suitable in an increasing interest rates scenario.
• Short and Medium–term Income Funds:These funds invest in instruments with maturities of up to 3 years. They are suitable to invest in when short term interest rates are higher and benefit from capital appreciation when the rates fall.
• Income Funds: Income funds are debt funds that aimed at providing stable returns to be paid out in any interest rate scenario, through active portfolio management. Although they are a type of debt funds, income funds can give negative returns in some cases. For example, if interest rates fall drastically, the underlying bond prices may also reduce. Or if the fund manager chooses to invest lower-rated instruments to increase returns, the fund may end up with default on interest payments, leading to negative returns.

Gilt Funds: Gilt Funds are mutual funds that invest only in government securities. The underlying securities do not carry any credit risk. However, gilt funds, due to their investment strategy, are among the higher risk debt products.They hold securities of varying maturities and it is essential to track your returns in gilt funds to exit at the right time. In the recent years, gilt funds have outperformed dynamic bond funds by giving 8-11% returns due to declining yields in a dovish interest rate scenario.

Dynamic Bond Funds: Dynamic Bond Funds tend to use a combination strategy of holding-to-maturity as well as trading of bonds for capital appreciation. It has exposure to both short-term and long-term securities, and therefore it is difficult to classify them according to time duration. They also perform well in a falling interest rate scenario by providing capital returns. They have given returns of 7-10% over a 3-5-year term in the recent past.

• Fixed Maturity Plans: These are closed ended debt funds in which the securities are held to maturity and the time frame of the fund is roughly matched with the maturities of the securities held.
• Hybrid Funds: These funds consist of a combination of debt and equity instruments in varying proportions. They carry a higher risk and reward compared to other debt funds due to the equity component.

FAQs

1. What is the tax treatment of returns on Debt Funds?

Returns on Debt Funds are taxed according to the tenure of the investment. In case of short-term funds (< 3yrs), the capital gains will be taxed at the time of sale as per the income tax slab rates. In case of long-term investment, the returns at the time of sale would be taxed at 20% with indexation as per section 112 of the Income Tax Act. Also, the interest earned (dividend) on the debt fund is tax free in the investors’ hands.

2. Are Debt Funds risk free?

No, there are a few risks attached to debt funds, though not as many as for equity funds.

• Interest rate risk: Interest rate risk arises from the change in the prevailing market rates, which affects the market value of debt securities. Long term debt instruments held in the funds increase the interest rate risk of the fund.
• Credit risk: This refers to the credit quality of the debt fund which is dependent on the credit rating of the instruments in which it has invested. Credit rating of the instrument denotes the ability of the issuer to repay its debt on time. Low credit rating will increase the default risk of the issuer, and consequently of the debt fund portfolio.

3. What returns can I expect from debt funds?

You can expect an average of 7-10% returns on an average in a debt fund, as compared to an equity fund which generates 12-17% returns. This also depends on the type of fund you choose. Long term funds like income funds or dynamic bond funds fetch higher returns than short term funds.

4. What are Income Funds?

Income Funds are primarily those that seek regular income pay-outs rather than growth of capital. They invest in debt securities where the interest is paid out on regular basis. Such funds are apt for those looking for sustenance income from their investment.

5. Why should I actively track my gilt fund?

Gilt Funds are mutual funds that invest only in government securities, both short term and long term. However, they are high risk due to their inherent investment strategy. Gilt funds are volatile, as they NAV is affected by the bond yields, interest rates and the change in supply of gilt securities. Sharp rise in interest rates may adversely affect the NAV while fall in rates can increase its value. Therefore, one needs to actively track interest rates and and enter as well as exit gilt funds at the right time.

6. What are Dynamic Bond Funds?

Dynamic Bond Funds tend to use a combination strategy of holding-to-maturity as well as trading of bonds for capital appreciation. It has exposure to both short-term and long-term securities, and therefore it is difficult to classify them according to time duration.  They also perform well in a falling interest rate scenario by providing capital returns. They have given returns of 7-10% over a 3-5-year term in the recent past.