The recent rally in debt funds came as a much-needed relief for investors as well fund houses, which saw their assets under management go up after some time. If you have missed the rally, you might be wondering whether there is still some steam left.
Before deciding on debt fund investment, let us first get a lowdown on the different types of debt funds available in the market. Debt funds are of four types: income or bond funds, liquid or money market funds, floating rate funds, and gilts funds. In terms of risk perspective, any debt fund carries liquidity and interest reinvestment risks, among others.
But income funds—which invest in long- and medium-term instruments like corporate bonds, debentures, fixed deposits, gilts— have an extra element of risk over gilt funds. The additional risk element is known as default risk because technically a government cannot default, though theoretically it can. Income funds that are overweight on corporate bonds carry the risk of default so they should pay that extra risk premium to the investors.
Before deciding on debt fund investment, let us first get a lowdown on the different types of debt funds available in the market. Debt funds are of four types: income or bond funds, liquid or money market funds, floating rate funds, and gilts funds. In terms of risk perspective, any debt fund carries liquidity and interest reinvestment risks, among others.
But income funds—which invest in long- and medium-term instruments like corporate bonds, debentures, fixed deposits, gilts— have an extra element of risk over gilt funds. The additional risk element is known as default risk because technically a government cannot default, though theoretically it can. Income funds that are overweight on corporate bonds carry the risk of default so they should pay that extra risk premium to the investors.
Why mutual fund route?
Lack of awareness about the fixed-income market and its complexities leads most of us to the route of mutual funds. The Indian financial market is predominantly equity driven, with very less information flow and awareness about the fixed-income or the bond market.
In the recent past, gilt funds which invest in central government and the state government papers have outperformed the income funds primarily because of easing inflation and the series of rate cuts. However, as I see, going forward the difference between the returns from these categories should come down. Recently, credit spreads of AAA-rated corporates had reached a level of about 415 bps before falling down to the current levels of 300 bps. Historically, AAA-rated corporate spreads have averaged around 120 bps since 2001. The spread is expected to come down over the next six months or so, as the RBI continues to pursue its monetary easing to tackle the slowdown.
As interest rates soften, the yield of the bonds decrease, but the price tends to increase. Once bond prices rise, this is reflected in a rise in the net asset value of debt funds.
Now, in a falling interest rate scenario, I expect the spreads of higher rated PSU bonds to decline. Further, going forward, lower inflationary expectations, coupled with further monetary easing, should lead to a further decline in gilt yields. This makes a classic case for investment in fixed income market for not-so-aggressive investors. A conservative investor should go for long-term debt funds with an investment horizon of two to three years. Gilt yields are likely to soften again once the RBI goes for more rate cuts. And spreads of the AAA-rated bonds are also likely to come down once economy starts picking up along with global economy.
Lack of awareness about the fixed-income market and its complexities leads most of us to the route of mutual funds. The Indian financial market is predominantly equity driven, with very less information flow and awareness about the fixed-income or the bond market.
In the recent past, gilt funds which invest in central government and the state government papers have outperformed the income funds primarily because of easing inflation and the series of rate cuts. However, as I see, going forward the difference between the returns from these categories should come down. Recently, credit spreads of AAA-rated corporates had reached a level of about 415 bps before falling down to the current levels of 300 bps. Historically, AAA-rated corporate spreads have averaged around 120 bps since 2001. The spread is expected to come down over the next six months or so, as the RBI continues to pursue its monetary easing to tackle the slowdown.
As interest rates soften, the yield of the bonds decrease, but the price tends to increase. Once bond prices rise, this is reflected in a rise in the net asset value of debt funds.
Now, in a falling interest rate scenario, I expect the spreads of higher rated PSU bonds to decline. Further, going forward, lower inflationary expectations, coupled with further monetary easing, should lead to a further decline in gilt yields. This makes a classic case for investment in fixed income market for not-so-aggressive investors. A conservative investor should go for long-term debt funds with an investment horizon of two to three years. Gilt yields are likely to soften again once the RBI goes for more rate cuts. And spreads of the AAA-rated bonds are also likely to come down once economy starts picking up along with global economy.
Key things to watch out
This brings us to some key things to look out while investing in the fixed-income mutual fund. First, investors should look at the quality of the portfolio of the fund as times are extraordinary now. A portfolio with more than 20 per cent exposure in gilt and more than 35 per cent of weightage in PSU bonds would be preferable. With the collapse of big institutions globally and expectation of rough times ahead, quality of the portfolio can make huge difference for any scheme.
It is also important to check the track record of the fund manager. In any mutual fund, the record of the fund manager along with the discipline of the fund house is very important. Prudent fund management should help in reducing risks.
Choosing between a between gilt and an income fund would depend upon the risk appetite of any investor.
Finally, the tax angle: For individual investors, long-term capital gains from debt funds are taxed by 11.33 per cent without indexation and 22.66 per cent with indexation. And dividend distribution tax is 14.16 per cent for debt funds.
This brings us to some key things to look out while investing in the fixed-income mutual fund. First, investors should look at the quality of the portfolio of the fund as times are extraordinary now. A portfolio with more than 20 per cent exposure in gilt and more than 35 per cent of weightage in PSU bonds would be preferable. With the collapse of big institutions globally and expectation of rough times ahead, quality of the portfolio can make huge difference for any scheme.
It is also important to check the track record of the fund manager. In any mutual fund, the record of the fund manager along with the discipline of the fund house is very important. Prudent fund management should help in reducing risks.
Choosing between a between gilt and an income fund would depend upon the risk appetite of any investor.
Finally, the tax angle: For individual investors, long-term capital gains from debt funds are taxed by 11.33 per cent without indexation and 22.66 per cent with indexation. And dividend distribution tax is 14.16 per cent for debt funds.
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