Factors That Determine the Risk in a Debt Fund

Debt mutual funds are those which are said to have a low risk of market volatility as they invest in fixed income instruments like bonds, deposits and money market instruments. Thus, debt mutual funds are preferred by investors who do not like market risks and want stable returns on their investments. That being said, it is a mistake to believe that debt mutual funds do not carry any risk at all. The returns offered by debt mutual funds are not guaranteed because these funds are also exposed to certain risks. So, when you invest in debt fund online, you expose your investments to such risks. Do you know which risks are associated with debt mutual funds?

Debt mutual funds basically have two types of risks – credit risk and interest rate risk. Let’s have a look at these risks in details –

What is credit risk?

Credit risk is also called default risk. It is the risk of default of realisation of the invested deposit. Debt mutual funds invest in bonds and money market instruments which promise a guaranteed rate of return on investment. These instruments also have a maturity period after which the invested money is returned. If, however, the instruments fail to return the deposit or the interest thereon after maturity, it would be a default and the risk of non-payment of the deposit is called the credit risk or default risk.

Credit risk of a debt instrument is measured by credit rating agencies which rate the instruments based on their repayment capacity. The ratings can be AAA, AAA+, AAA-, B, D, etc. The higher the rating the lower would be the credit risk. Thus, fund managers try and pick debt instruments which have a high credit rating so that the credit risk of the portfolio is minimized. Moreover, if the instrument carries a high credit risk, it would also offer a higher return. So, if you are investing in a debt fund online which has a high return, you should check the credit rating of its underlying assets.

The credit rating of instruments is done periodically and if the rating of an underlying asset falls, the value of the asset also falls, which, negatively impacts the debt fund portfolio.

What is the interest rate risk?

Interest rates on debt instruments are not fixed. They are dynamic in nature which changes with the changing economic conditions. If the interest rates rise in the markets, the market price of the bond falls and vice-versa. Since debt mutual funds invest in bonds, a fall in the bond price reduces the fund’s value and the returns are reduced.  

So, when you are looking for the best debt fund, consider the interest rate risk of the fund vis-à-vis the modified duration. The concept of modified duration is used to measure the price sensitivity of the bond with a specified change in the interest rate. When the change in the rate of interest is multiplied by the modified duration, the expected change in the price of the debt fund can be ascertained. 

To invest in the best debt fund, choose funds whose portfolio has lower weighted average maturity duration. Such funds carry a lower interest rate risk than funds whose portfolios have a longer weighted average maturity duration.

Factors which determine the credit risk and interest rate risk in a debt fund include then following –

• Repo rate – if the repo rates fall, the value of the debt fund portfolio rises

• FII investment – if there is a heavy FII investment in debt instruments, the value of the debt fund portfolio would rise

• Domestic and international economy – economic factors directly impact the interest rates on debt instruments. They, therefore, directly impact the interest rate risk carried by debt mutual funds

Bear in mind these risks inherent in debt mutual funds when you invest in them. To invest in a debt fund online you can download the ETMONEY APP. It is a personal finance app which allows you to invest in the best debt fund. You can compare the performance of different debt fund online through this personal finance app and then choose one which offers the best returns at minimal risks. You can also invest online with minimal hassles at zero commissions and start your debt fund investments instantly. So, know the risks of debt funds and then invest in them through ETMONEY’s personal finance app for ease and convenience.

How you will get indexation benefit through Medium duration fund investments?

Debt fund schemes in India offer a wide range of investment options to investors, especially ones with a low-risk appetite or who want to avoid market volatility. With SEBI’s categorization and rationalization exercise in 2017, there are currently 16 debt fund schemes in India. Investors have ample choice available and can opt for a scheme which is in line with their investment objectives. 

This article will give you an overview of medium duration funds. 

Meaning of Medium Duration Funds

Medium duration funds are open-ended debt schemes that invest in instruments (debt and money market) such that the Macaulay duration ranges between three years and four years.

Medium duration fund investments have a longer maturity period than six debt variants (overnight, liquid, ultra-short, low duration, money market, and short duration funds). However, their maturity tenure is lower when compared to medium to long duration and long duration funds. This debt scheme is more likely to have higher interest rates, especially when compared to the shorter duration debt funds. Medium duration fund investments are ideal for investors who have a medium investment tenure (at least three years), low-risk preference, and are content with moderate returns. 

Indexation benefit for medium duration funds

For the purpose of taxation, medium duration fund investments (being debt schemes) qualify for indexation benefits. This benefit is applicable for long-term capital gains or when the investments are redeemed after a minimum period of three years. Indexation allows adjustments in the initial purchase price of your investment to account for inflation. The purchase price is inflated basis the inflation index of the year of purchase. As a result, your net gains go down and so does the tax payable.

Here is an example of how indexation helps to bring down your tax liability.

In August 2015, you put in Rs. 10,000 towards medium duration fund investments. You were allotted 1000 units at the NAV of Rs. 10. In the year 2019 (July) when the NAV had reached Rs. 20 you decided to redeem the investment. The value of your investment at that time was Rs. 20,000 (1000 units * 20 NAV per unit). 

Hence, your capital gains from this transaction were Rs. 10,000 (i.e. Rs. 20,000 – Rs. 10,000). However, as your investment holding period was more than three years you will and get the benefit of indexation. As a result, you will not need to pay tax on the amount of the entire gain of Rs. 10,000

In order to determine the taxable income, the Indexed Cost of Acquisition will be computed as:

Original investment or acquisition cost multiplied by (CII** of the redemption year divided by CII** of the acquisition year)

= 10,000 *(289/254) =Rs. 11,378

(**CII stands for the Cost Inflation Index. This value is determined by the Central Government. CII for the FY 2015-2016: 254. CII for the FY 2019-20: 289) 

Your net gains (for the purpose of taxation) from the sale transaction would now be Rs. 8622. The tax payable would be Rs. 1724 (20% Tax rate) as compared to Rs. 2000 without indexation.

Final Words

Indexation is the USP of debt fund schemes in India. It gives them an edge over conventional investment options such as FDs, etc. Medium duration fund investments, due to their longer maturity period amps up the potential for generating higher returns for investors. This coupled with indexation benefits makes medium duration fund investments a total win-win deal! But remember that indexation benefit kicks in only once you complete three years. Longer you remain invested, lower is likely to be your long-term capital gains tax. 

Choose dynamic bond funds that have good track record and performance

We all know that markets are highly dynamic in nature. So, why shouldn’t our investment options also be the same? Luckily we have dynamic bond funds to cater to this need.

What are dynamic bond funds? 

Dynamic Bond Funds belong to the category of debt funds. As per SEBI guidelines, these open-ended debt funds have the flexibility to invest across varying durations. They can invest in short-term bond funds in one month and long-term in another, basis the direction being followed by market interest rates.

Dynamic bond fund investments are taxed as per other debt funds. If the holding period is three years or more, the returns are taxed as Long-Term Capital Gains (20% tax rate with indexation benefit). Short-term capital gains (if the investment is redeemed before three years) are added to overall income and taxed basis the applicable income tax slabs.

How do these debt funds work?

Dynamic Bond funds seek to generate higher returns by switching between varied durations basis the market conditions. Bond prices and interest rates are inversely related to each other. When the interest rates go down, bond funds with longer durations get rewarded handsomely. However, in case the interest rates climb up, these funds stand to lose out a lot. Fund managers in charge of dynamic bond funds can reduce the duration (when interest rates are going up) to soften out the blow from dwindling bond prices. Similarly, they can increase the duration of the underlying investment so as to capitalize on the rising bond prices.

Hence, if you invest in dynamic bond funds, your debt funds risk is managed and the potential for earning higher returns is also enhanced.

Factors impacting the success of dynamic bond funds

1. Performance

What do you do before making any online purchase? Read the reviews to see how the product has fared for others. Similarly, before you invest in dynamic bond funds, you should analyze the performance (in absolute terms as well as in relation to benchmark and peers) for a period of at least 3 to 5 years. Going by just the last year’s performance scorecard is likely to result in wrong choices.

2. Fund House

If you wish to invest in dynamic bond funds, then you need to choose a fund house with a healthy track record. Factors such as technical research, market knowledge and understanding and agility to respond to changing market conditions play a crucial role in maximizing the returns as well as managing the debt funds risk.

3. Fund Manager

Dynamic Bond Funds are reactionary in nature. The success of these funds relies heavily on the fund manager’s ability to catch the troughs and peaks of the interest rate cycle and change the duration accordingly.

Risk in dynamic bond funds?

Debt funds generally have lower debt funds risk quotient and are considered suitable for conservative investors. However, those who are looking at investing in dynamic bond funds need to have a healthy risk appetite. This is because sometimes the trend (for interest rates) is not clearly visible. There are times when the fluctuations (up as well as down) happen very swiftly (too fast for even the best fund managers) and these debt funds get hit severely.

Best of the lot

If you want to invest in dynamic bond funds, you should consider these top-performing schemes:

1. ICICI Prudential All Seasons Bond Fund
2. Edelweiss Dynamic Bond Fund
3. Mirae Asset Dynamic Bond Fund
4. Kotak Dynamic Bond Fund
5. Aditya Birla Sun Life Active Debt Multi Manager FoF Scheme
6. Quantum Dynamic Bond Fund
7. Tata Dynamic Bond Fund
8. Quant Dynamic Bond Fund
9. IDFC Dynamic Bond Fund
10. L&T Flexi Bond Fund

Final Words

Dynamic Bond funds need to be given a minimum of three years (five years for optimum results) to get the most out of your investment. A value research study revealed that at the 3-year time juncture, the outperformance of dynamic bond funds (over short-term funds) was around 60%-70%. The figure jumped to 80%-90% at the five-year time frame.

Invest in dynamic bond funds if you have the appetite for higher debt funds risk and hunger for higher returns!