Benefits of investing in debt funds

The decline in the Indian and global equities market has finally brought us to the conclusion: what had began as a global liquidity glut four years ago has eventually ended as a liquidity crisis in 2008!
In the current recessionary scenario, opportunities for investments are limited and fraught with risk.
In such a backdrop, an investor’s choices with regard to alternative investment avenues are restricted and involve considerable uncertainty. It is no surprise that a majority of the investors choose to switch into a much-safer investment class — debt oriented funds.
A debt fund is a diversified portfolio of assorted debt and money market instruments managed by professional managers of a mutual fund.
A stake in this is available to the general investor at an equally apportioned price of the ‘total portfolio value per unit’ .
This is also known as NAV(net asset value). So for all practical purposes, a debt fund is a simple proxy to investment into debt as an asset class.
Debt funds can be categorised into various sections based on the specificity of securities they invest in, timehorizon and the objective. These would be namely: income / bonds funds, liquid/ money market funds and gilt funds. The maturity of securities, which these debt schemes invest in, may vary according to the scheme objective and investment strategy.
But their investment universe largely ranges from treasury bills, commercial paper, corporate deposit and repos for the short-horizon funds to corporate bonds, gilts, debentures and fixed deposits for long-term debt funds. In this categorisation, the only break is gilt funds that invest in sovereign papers of central and state governments.
Another addition to the debt fund category is fixed maturity plans (FMPs), which are nothing but close-ended debt funds and invest according to the scheme maturity and investment pattern as provided by the scheme mandate. The key advantage of debt funds is the near assurance (not always) of the flow of periodic income to the investor by way of interest/ coupon payment (or on deepdiscount ) on a largely pre-fixed rate of return.This ‘pledge’ of ‘return’ ensures that the pricing of the future cash flow is largely accounted into.
This ensures a significantly reduced volatility (risk) in prices of the underlying debt assets (and thus the NAV) of the fund.
In the case of liquid funds, the risk associated with NAV volatility tends to be almost negligible.
To compare and contrast: the volatility in annualised returns (risk) of Crisil Liquid Fund Index was 0.60% as on November 30.
During the same period, the volatility in annualised returns (risk) of Nifty Junior, Nifty and Sensex was at 38.06%, 32.99% and 31.98%, respectively . The difference is stark!
In all fairness, debt-based investments face credit risk and interest rate risk.
But even here, in case of gilt based funds, the credit risk is absent, making it a near risk-free investment (however, interest rate risk remains prominent here).high quality debt-papers backed by an asset guarantee to ensure capital safety.
In sum, the cornerstone of debt funds is the nearly ascertained yield on investment with a satisfying protection to capital.
The comparably low risk attached with the debt fund investments may in-turn , invite a hypothesis that: “the commensurate return on debt funds too may be low, given the low risk” .
This is not entirely untrue! But debt funds do exhibit high return potential in a given set of circumstances.
Especially during a declining phase of the interest rate cycle, when the rally in the secondary gilt and bond market provides the majority of debt funds the opportunity to profit from high prices of the securities.
The debt funds thus find themselves in an advantageous position to benefit from the bond rally, and are potentially inclined to provide double digit returns.Debt mutual funds also gain significant tax arbitrage advantage against a very popular investment tool in Indian financial landscape — fixed deposits (FDs).
The returns on FDs are fully taxable to the extent of 33.99%. In comparison, income from debt funds is taxed according to the scheme’s characteristics.
The dividend income from liquid funds invites the tax incidence of 28.325%, whereas dividend income from all other debt funds are taxable at 14.1625%.
In case of growth schemes, where income accrues as short term capital gains, the tax incidence would be as per the tax slab.
Whereas in case of long-term capital gains from debt mutual funds, the incidence of taxation would be 10% flat or at 20% with application of indexation.
Thus, invariably in all cases, the investor stands to make a higher net return on investment vis-a-vis FDs due to tax arbitrage.
Given the scope, dimension and dynamism of investor needs, the investment in debt funds must be planned after realistic appreciation of the risk-reward trade-off and the investment horizon incumbent to such debt asset.
Yet, even in case of equity-oriented investor , the presence of a debt fund in their portfolio accords a stable grounding to the overall portfolio, and tends to restrict the downside of the investments during the market downturn.
I would thus like to reiterate that investors have been presented with a unique opportunity by the present Indian debt market, wherein the declining interest rate cycle has triggered a major rally in gilts.
However, the credit spread between gilt and commensurate corporate bond paper continues to linger in excess of 300 bps, and hints of a likely rally in the bond market as well.
This may prove to be a significant investment opportunity for an investor with a 6 month to 1-year timeline.
Sandesh Kirkire, CEO, Kotak Mahindra Mutual Fund

Source: http://economictimes.indiatimes.com/quickiearticleshow/msid-3868912.cms