Understanding key characteristics of debt funds

Up until now, you’ve seen how several government and corporate debt instruments work on a standalone basis. While they each come with their own set of advantages for the investor, it may prove to be difficult for the average retail investor to keep track of the auction process for G-Secs or to keep an eye out for corporate bond issues. Furthermore, if you’re a new investor in the debt market, choosing the right debt instruments may be difficult.

Here’s where debt funds prove to be highly useful.

What are debt funds?

Debt funds are mutual funds that invest primarily in the debt market. Generally, these debt funds choose to park the investors’ funds in a mixture of debt or fixed income securities like government securities, T-bills, corporate bonds, and many other money market instruments and debt securities.

Debt funds are managed by professional fund managers, who make decisions about the debt instruments to invest in and the debt instruments to sell. The credit rating of the asset is one of the key factors that fund managers take into account when they’re making decisions about which debt instruments to invest in.

Credit rating of debt funds

Let’s take a look at two different debt securities:

1. A bond issued by a management services company, offering interest at 7% annually
2. A bond issued by the government, offering interest at 7% annually

Which of these two bonds do you choose to invest in?

The obvious choice would be option 2 - because the bond comes with the government’s sovereign guarantee.

Now, let’s switch things up a bit. Take these two securities:

1. A bond issued by a profitable, established, 30-year old company, offering interest at 7% annually
2. A bond issued by a young, 3-year old company, offering interest at 7% annually

Here, which bond would you choose to invest in? We’re guessing option 1, because that company has a better track record than the other one, right?

So, this goes to show that each debt security comes with an inherent risk of default. From the example seen above, here’s how the risk of default stands.

• Government securities come out as the safest options
• Corporate bonds issued by companies with an impeccable financial track record carry negligible risk of default
• Corporate bonds issued by newer companies with a good record come with a very low to low risk of default
• Bonds issued by companies that have a poor financial record come with medium to high default risk

To help investors and fund managers make smarter decisions about investing in the debt market, credit ratings companies like CRISIL, CARE, FITCH and ICRA issue ratings to different debt securities. By keeping these credit ratings as a point of reference, debt managers take calls on which debt instruments to invest in. So, if you are unsure about assessing different debt instruments on your own, debt funds can prove to be a convenient alternative, since experts assess the available options and pick the right instruments to constitute the debt fund’s portfolio.

To understand debt funds further, let’s take a closer look at the primary features of these mutual funds.

Key characteristics of debt funds

Getting to know the key characteristics of debt funds can make it easier for you to understand how investing in these funds can impact your investment portfolio and your goals. So, let’s get into the details.

• Low risk

If there’s one key character-defining trait of debt mutual funds, it is the low amount of investment risk that they carry. This is primarily due to the fact that debt mutual funds invest in debt instruments such as corporate bonds, government securities, debentures, and other money market instruments. And depending on the issuing entity, the chances of default on debt instruments are almost little to none.  

Unlike equity funds, debt mutual funds don’t undergo significant changes in their value despite market changes. This makes them far more stable than their equity counterparts. As a result, they turn out to be far less risky. In fact, the only metric that really has an impact on debt funds is the current interest rate in an economy. Although the interest rates do change from time to time, the fluctuations are not as extreme as equity market movements.

• Capital preservation

The value of a stock is ultimately determined by the forces of demand and supply. And so, the potential for upside for a stock is only limited by the demand for the said stock. Virtually speaking, the demand for a stock can be endless. However, that’s not the case for debt funds. Since these funds invest in fixed-income securities, there’s very little scope for wealth creation by capital appreciation. Instead, debt instruments excel at capital preservation. The same cannot be said for equity, because the losses, just like the gains, can be potentially limitless.  

When you invest in debt funds, you’ll receive a steady, fixed rate of interest throughout the tenure. In addition to this, the amount of investment that you made will also be paid back at maturity. You can also choose to reinvest the interest that you receive regularly back into the funds. This will increase your interest in the coming years, as well as your maturity payouts. 

Think of it like a fixed deposit where the interest is reinvested in the FD. When you do this, you increase the possibility of capital appreciation from your debt funds by a small margin. 

• Limited duration

Since debt funds invest in fixed-income securities, the holding period is limited. It varies according to the type of fund. In the coming chapter, we’ll delve deeper into the different types of funds. But at this juncture, keep in mind that an investor cannot hold onto debt mutual funds forever, unlike an equity mutual fund. 

This is because bonds and other debt instruments, just like bank FDs, come with a pre-decided maturity date, as you’ll recall from our discussion in the previous chapters. At the time of maturity of the funds, you get back all of your investment principal along with the requisite interest payments due at that point, if any. 

Here’s an example that can help you better understand the concept. Assume that there’s a debt fund with a maturity date of 110 days. Since the holding period of the fund is limited, which in this case is 110 days, you can hold the fund only for that period. Upon maturity of the debt fund, you will receive your initial investment along with the requisite interest payments.

• Credit ratings

Recall our discussion on credit ratings from earlier in this chapter? Corporate bonds, debentures, commercial papers, and other instruments that debt funds invest in are rated by credit rating agencies. A high credit rating is a testament to the repaying ability of the entity issuing the debt instrument. On the other hand, a low credit rating might mean that the issuer’s repaying ability is weak and that the chances of the issuer defaulting on repayments is high.   

Credit ratings give investors some much-needed information on the quality of the instrument and the risk associated with it. They help you make a much better and more informed decision. Credit ratings also make categorization of debt funds easier. For instance, low-risk debt funds only invest in debt instruments that are highly rated. Whereas, other debt funds such as corporate bond funds tend to invest in instruments that may not be as highly rated. 

Wrapping up

So then, that’s about it with respect to the key features of debt funds. Now, if you’re eager to find out more about the different categories of debt funds available in the debt market, head to the next chapter.

A quick recap

• Debt funds are mutual funds that invest primarily in the debt market. 
• Generally, these debt funds choose to park the investors’ funds in a mixture of debt or fixed income securities like government securities, T-bills, corporate bonds, and many other money market instruments and debt securities. 
• Debt funds are managed by professional fund managers.
• Debt funds carry very low risk, primarily due to the fact that debt mutual funds invest in debt instruments such as corporate bonds, government securities, debentures, and other money market instruments. 
• Depending on the issuing entity, the chances of default on debt instruments are almost little to none.
• They also help preserve capital rather than appreciate it.
• Since debt funds invest in fixed-income securities, the holding period is limited. 
• Corporate bonds, debentures, commercial papers, and other instruments that debt funds invest in are rated by credit rating agencies. 
• A high credit rating is a testament to the repaying ability of the entity issuing the debt instrument. 
• On the other hand, a low credit rating might mean that the issuer’s repaying ability is weak and that the chances of the issuer defaulting on repayments is high.