It’s straightforward to comprehend where and how equity funds invest and generate returns. They acquire and dispose of equity securities. When stock prices increase, equity funds often benefit.
However, debt markets operate differently. Described, it is a marketplace for borrowers seeking to borrow money and lenders wanting to lend. It is critical to make interest and principal payments on time. And because individual investors are frequently unable to purchase them directly (the face amount of a bond is generally about Rs 1 lakh), there is a lack of information regarding how much debt products work.
What types of investments do short-term debt funds make?
Banks, non-bank financing companies (NBFCs), public sector entities (PSUs), enterprises, and the government issue these money market instruments to cover their short-term funding needs. Typically, such funds invest in instruments with a one-year maturity. TREPS (Tri-Party Repo), repurchase agreements (repo), Certificates of Deposit (CDs), Commercial Papers (CPs), and T-bills are only a few of the instruments available.
Repo and TREPS are used to make loans for brief periods, such as overnight or up to a year. Repo enables banks and non-bank financial companies (NBFCs) to borrow money by pledging government securities as collateral. Additionally, these organizations can lend in the repo market. Surprisingly, mutual funds are limited to lending in the repo market (barring extreme conditions).
The RBI recently permitted repos to be collateralized by corporate bonds to revitalize the debt market.
Surprisingly, even equity funds use the repo market to store short-term excess liquidity.
Additionally, short-term debt funds invest in certificates of deposit, commercial paper, and Treasury bills. Additionally, they are mechanisms that let borrowers – banks and corporations – to borrow money for short-term purposes. Banks issue certificates of deposit, corporations issue certificates of participation, and the government issues T-bills through the RBI. CDs are often rated higher than CPs and have a higher credit quality. Additionally, this is why CPs have somewhat higher interest rates to compensate for their occasionally poorer credit rating.
The majority of these products are zero-coupon bonds issued at a discount. For example, a three-month T-bill with a face value of Rs 100 may be issued at Rs 98, a saving of Rs 2. The issuer repays the face amount of Rs 100 upon maturity. Thus, the investors receive a return of Rs 2.
While short-term debt funds devote a sizable amount of their assets to such investments, long-term debt funds also devote a sizable portion. However, as the graphic indicates, short-term debt instruments offer significantly smaller yields.
Where do long-term debt funds make their investments?
Government securities are the safest long-term instruments (g-secs). The central government needs finances to operate daily and finance the fiscal imbalance. Apart from other sources of financing such as taxation, it also borrows money from the debt markets via the RBI, its banker, by issuing g-secs. Additionally, state governments borrow through the issuance of State development loans (SDLs).
G-secs can have maturities of up to 40 years. These instruments are the safest and most liquid since the state guarantees them back. G-sec mutual fund schemes invest primarily in these gilt securities. However, other debt and hybrid funds also hold g-secs to control their credit mix duration (interest-rate sensitivity).
Bonds and Debentures
Similarly, they issue bonds and debentures when businesses want long-term financing. These are available in terms ranging from one to fifteen years. However, corporate bonds are not backed by the government (unlike g-secs and T-bills), so they entail a more significant credit risk. Additionally, they pay higher interest rates to compensate.
As a result, bonds also have credit ratings. Unless you invest in a credit risk fund, choose bonds that invest a significant portion of their assets in highly rated securities. Generally, government-owned enterprises’ bonds are deemed safer than those issued by private companies; however, this is not always the case.
Notably, short-term debt funds also invest a portion of their assets in G-Secs and bonds with a short residual maturity, typically less than a year.
Securitized debt instruments are securities created through the securitization of individual loans.
Simply put, a bank has a Rs 1000 crore vehicle loan portfolio. To raise capital, the bank generates debt instruments (known as pass-through certificates or PTCs) backed by the underlying asset, the vehicle loan portfolio, and sells them to mutual funds and other investors.
Technically, a securitization transaction comprises the originator (the bank) selling receivables to a Special Purpose Vehicle (SPV), often structured as a trust. Investors (mutual funds) are issued rated PTCs, with the proceeds paid to the originator as recompense.
Rating agencies assign ratings to these securitized debt securities. Mutual funds seek to invest in only AAA-rated companies.
The risk associated with investing in securitized debt is comparable to that of investing in debt securities. In January 2019, many debt funds managed by Aditya Birla and HDFC mutual funds were impacted after the SPVs of two IL&FS-owned road projects that they held defaulted on interest payments.
Several mutual fund schemes invest between 0.2% and 10% of their portfolios in these products.
Among the hazards associated with debt, funds are interest rate risk (sometimes referred to as duration risk, market risk, or volatility risk) & credit risk (also known as default risk). What we will describe is not so much a new risk management discovery as it is evolving in the current state of the debt market.
Apart from the credit rating, another indicator of a debt fund’s soundness is the month-to-month change of the portfolio corpus size. If the fund’s corpus is continuously and considerably shrinking, the fund is under strain. If the corpus size is not consistent, a small amount of negative CA in the portfolio (say -2 or -3 per cent) is not a problem. Additionally, a healthy CA surplus fund is better positioned to withstand any redemption pressure. Because liquid funds undergo redemption pressure in March due to corporate advance tax payments, they should not be rated solely based on March outflows. For portfolio size changes in other debt fund categories, the observation period should be more extended, say the previous six months. Corpus fluctuation is minimal for funds with a high-quality portfolio, and you may remain invested.
This article should give you a good idea of treps in mutual funds and treps investment in mutual funds.