Mutual fund investments : Debt MFs less popular, but offer efficient option

When we talk about mutual funds (MF) investors typically associate them with equity-oriented schemes which are also popular for their ability to generate higher returns over a period of time.

But, there are lesser popular but efficient cousins in the form of debt mutual funds. These have remained out of the limelight in both the investor minds and media alike purely because corporates have been the biggest contributors to the assets under these categories.

Debt MFs form over 50 per cent of the entire Assets Under Management (AUM) by the mutual fund industry as per the Association of Mutual Fund in India (AMFI) data as on December 31, 2018. More than, 70 per cent of the contribution remains by the corporates while retail investors form very negligible contributors to this AUM.

Now, does it reflect just the lack of awareness or the actual utility in these categories would be dwelled in this article.

Debt MF are a category of funds that generate returns by investing the money in bonds and/or deposits of various forms. In simple terms, they generate income from by lending for a particular period of time to certain entities usually institutions, corporate bodies, etc. for an interest.

This interest is passed on to the unit holders and thus becomes the return for the investors of these funds. The instruments these funds include bonds (of government or quasi-government) certificate of deposits (CD), commercial paper (CP), Gilts and lending instruments to other institutions, etc.

Bonds are nothing but instruments which clearly mention agreement between the borrower and lender, the exact amount, the consideration for lending and the time period at which these are matured or expired.

Here, consideration is the interest that is paid at a periodicity. These are similar to the deposits in a bank or post office where an individual puts in money and earns a rate of interest at specified interval.

The difference here is that these are governments (state/central), local bodies (municipalities), larger corporates or institutions that borrow larger sums of money while the interest paid is dependent upon their repayment capacity, demand for their bonds, and time period etc.

Debt MFs invest in these kinds of bond depending upon the fund objective that ensures the liquidity, risk and timelines. So, the type of instrument a particular fund invests depends upon its objective which should be a prime or of most importance for the investor to look for.

Going further into explanation, these bonds and most of the other debt instruments the MFs invest are tradable unlike the FDs individuals invest in. Though a FD could at best be acted as a collateral, the bond while trading could give an additional gain depending upon the demand for them by market participants.

These gains when traded are also accrued to the MF unitholders apart from the interest the bonds generated.

But, the flipside of this is that, when the bond loses sheen or demand in the market then it would attract lesser players or no players which would bring the price of the bond and when a fund sells at a lower valuation, the fund and thus their unitholders incur loss to that extent.

Though, a lower valuation if not sold would still pull down the overall valuation of the fund, would continue to earn the interest income. The price fluctuation in bond prices is a direct correlation to the interest rate cycle of the market. However, other factors of default, liquidity, etc. also govern the demand and thus the bond prices.

So, the risks associated with debt MF investments are liquidity (when a particular corporate or institution undergoes credit crunch or debt servicing issues), default (solvency of a corporate or institution which has borrowed the money), rating (provided by independent agencies considering their cashflows, profitability, assets and servicing capacity) and interest rate regime (which is primarily market driven but partly central bank controlled).

Depending upon liquidity, safety or return requirements, investors could opt for MFs which cater to these situations like ultra-short to short term funds, liquid funds on one extreme to long-term debt and Gilt funds on the other extreme with bond funds, credit opportunities and dynamic bond funds in between.

The risk to reward in each of these funds vary and investment returns are subjected to debt taxation for the investors.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)