Debt Mutual Funds How Works

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Debt Mutual Funds – Easy to Understand Debt funds are funds that invest in “debt instruments”, which include government securities, corporate bonds and money market instruments. These are called debt instruments because the issuers have borrowed money from the lender (investors) by issuing these securities. These “debts”, mainly known as “bonds”, are income generating properties i.e. investors receive regular interest payments on them. These payments could be monthly, semi-annually or annually. However, many of the most attractive debt instruments are unavailable directly to the retail investors. But, they can invest in those debt instruments indirectly through debt funds. For retail investors Debt Mutual Funds are the best way to invest in debt i.e. income generating instruments.

Ideally debt funds are of three main types: Income/bond schemes They invest in long- and medium-term instruments like corporate bonds, debentures, fixed deposits. These are designed for corporate and small businessmen to use for cash or treasury management. These schemes allow them to park short-term surplus funds in the money market, so that they earn some return before they find end uses. They invest in money market instruments like call money, inter-corporate deposits and commercial paper. Their returns range from 8 to 12 per cent, depending on money market conditions. Even salaried individuals can use them in the short term, since they offer better returns than savings accounts. Risk comes from money market volatility - which also creates the possibility of gain due to a sudden increase in rates. Also risk arises from the quality of paper held and from unjustifiably large exposures to particular companies or sectors. Income schemes usually offer the best returns among those investing in various forms of debt. However, these superior returns do come at the cost of slightly higher risk. In addition to the standard income and growth options, several schemes are now offering a third choice: dividend reinvestment. Here, tax-free dividends due to you, which you might otherwise have spent, are reinvested in the fund, getting you more units. This is a more efficient process of capital building.

Liquid/money market schemes They invest in instruments having short-term period like treasury bills, commercial paper, call money and repos. These are designed for corporate and small businessmen to use for cash or treasury management. These schemes allow them to park short-term surplus funds in the money market, so that they earn some return before they find end uses. They invest in money market instruments like call money, inter-corporate deposits and commercial paper. Their

www.kgandhi.anindia.com returns range from 8 to 11 per cent, depending on money market conditions. Even salaried individuals can use them in the short term, since they offer better returns than savings accounts. Some funds even offer cheque-writing facilities. Risk comes from money market volatility - which also creates the possibility of gain due to a sudden increase in rates.

Gilt Funds Gilt is a British term and initially referred to the debt securities issued by Bank of England that had a “guilt” (guild that means painted with gold) edge. However, now Gilt funds refer to funds that invest in sovereign papers issued by the central government and the state governments of any country. The maturity period in these funds are medium- and long-term, depending upon an investor’s goals. Government securities, or Gilts, are the most liquid debt instruments. They offer excellent investment opportunities for fund managers. Also, the yield gap between AAA-rated debt (the highest safety rating) and gilts has fallen from over 1 percentage point over the past three to seven years to 0.5 percentage points during the past year. Gilt schemes are for those with the least risk-tolerance and a willingness to take a small cut in returns, relative to income schemes. In fact, it's possible for a pure gilt scheme to outperform a regular income scheme. In the past six months, many mutual funds have launched gilt schemes. The returns range from 9 to 12 per cent. Most of these are open-ended, no-load funds - the best, since they ensure liquidity. There are some other type of debt funds and include: Monthly income plans (MIPs): Here every month a fixed amount is invested of which approximately 20% is allocated to equity and the remaining to debt. A fixed maturity plan (FMP) is a close-ended scheme, and has an exit load, if redeemed, before the maturity period. Such schemes can have a maturity period of three months to three years. It selects an instrument, which corresponds with its maturity period. For instance, if the maturity of a scheme is one year, then the scheme will invest in instruments having one-year maturity. As the instrument will have a fixed interest rate payable on quarterly/half-yearly basis, the NAV will be on interest accrual basis.

Why invest in debt funds? We clearly know one thing – equity on an average gives much higher return than debt; almost twice over a period of time. Then why invest in debt? The main reason is to avoid the uncertainty and volatility of the stock market. Probably all of us are now aware of the effect of global financial crisis where Sensex crashed from 21,000 to 8,000 within 6 months and investors lost billions of dollars. There were some sad incidents where brokers and investors committed suicide because of huge loss in the stock market. Hence, risk of losing even your principle money is high in stocks. But still people are attracted towards equities because it offers very high return. And there is no harm in it.

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The other big advantage of investing in debt is regular income generation. Debt funds are probably the only way to invest in income-generating instruments without having to commit huge sums of money, or without worrying about transaction costs, stamp duty or lack of liquidity. The third reason for investing in debt funds is to diversify your portfolio. There is a famous adage saying “Do not put all your eggs in the same basket.” Even if you are a die-hard equity investor, it is recommended to put some money in debt instruments so that you have some guarantee of return as well as regular income. In case of stock market crash your debt component will be safe. In fact in such scenario debt investors give better returns than equities. The fourth and a very important reason for investing in debt funds is tax benefits. Though opting for dividend option in liquid/money market schemes attracts net dividend distribution tax of 28.325% and the remaining debt schemes (like gilt, income/bonds) attract 14.16% tax in the hands of mutual funds, these taxes are paid on behalf of investors by the mutual fund company. Government way back in 1999 removed double taxation on dividend benefits and hence dividends are tax free for investors.

Returns and Liquidity of Debt Mutual Funds After looking at the performances, it is seen that in the last one year, short-term or liquid funds have been the best performers among all the categories, considering returns generated by the majority of the schemes in this category. The schemes generated a return in the range of 7.5-8%. In this the majority of the funds are allocated to call money, repos, commercial paper (CP), certificate of deposit (CD), fixed deposit (FD), etc. Medium- and long-term funds invest in bonds, non-convertible debentures and fewer amounts in CP and CD. These have generated a return in the range of 7%-7.5%. Debt funds offer tremendous scope for most investors. One can get liquidity, and most importantly, a regular flow of income. However, it has a risk attached as compared to fixed deposits. But considering the benefit of tax arbitrage and the imposition of penalty on withdrawal before maturity in fixed deposits, liquid funds are a better option, though returns in both fixed deposits and liquid funds are more or less the same. On the other hand, FMPs are relatively less risky than income funds as they have fixed maturity, which gives fixed returns according to the time period selected.

Best Performing Debt Funds Below is the list of Top 10 Debt Mutual Funds ranked based on their 5 years return.

www.kgandhi.anindia.com Mutual Fund Scheme Canara Robeco Cigo-G HDFC MIP Long Term – G Reliance MIP ICICI Pru Gilt Investment PF-G UTI MIS Advantage – G ICICI Pru Income Multiplier Reg-G Principal MIP PlusG Canara Robeco Income-G DSPBR Savings Manager Agg-G HSBC MIP SavingsG

Inception Date

Fund Corpus*

1Month

3Month

1-Year

3 Years

5 Years

April, 2001

6.61

1.46

11.42

19.86

15.08

15.06

907.17

2.75

18.91

19.52

12.22

13.14

186.69

2.38

13.00

25.71

12.59

12.48

106.00

-1.3

7.00

40.86

18.05

12.25

85.91

2.54

12.69

15.69

11.24

11.94

185.65

1.98

16.11

13.82

9.36

11.89

61.52

1.33

12.77

11.65

12.03

11.05

374.96

0.13

4.78

29.52

13.99

11.02

May, 2004

58.25

2.37

8.96

12.46

10.49

10.97

February, 2004

111.11

2.39

10.46

12.38

11.40

10.86

December, 2003 December, 2003 November, 2003 December, 2003 March, 2004 December, 2003 September, 2002

Buying the Right Debt Fund The aim of this article is to enable you to select your own fund. Indeed, there is little need for professional advice while choosing a debt fund. As long as you are clear about what each kind of scheme (listed at the start of the article) can offer you, as well as what your investments need are, it's not hard to select “your fund” from the choices available in the market. However, if you are still looking for advice in investing in Mutual Funds, visit our website www.kgandhi.anindia.com has experts to help you realize your dreams or call 09271267305 Regards, Kirang Gandhi Corporate Financial Planner www.kgandhi.anindia.com M-9271267305