Debt Funds In India: Worth The Investment Risk?

Debt funds are a type of mutual fund that generates returns by lending money to governments and companies. They are considered a low-risk investment option as they invest in fixed-income securities such as bonds, providing a stable income stream and capital preservation while also diversifying investment portfolios. The lending duration and type of borrower determine the risk level of a debt fund. In India, debt funds are taxed differently depending on the duration of the investment. Short-term capital gains are taxed at the income slab rate, while long-term capital gains are taxed at 20% with indexation benefits. Debt funds are ideal for investors seeking regular income, conservative or first-time mutual fund investors, and those who want to park short-term funds.

Debt funds vs fixed deposits

Debt funds and fixed deposits (FDs) are both investment options in India, but they have some key differences. Here is a comparison of the two:

Risk

Fixed deposits are considered a safe investment option as they offer a guarantee of capital safety by the bank. While bank defaults are rare, they are possible, and in such cases, investors' deposits are guaranteed up to ₹500,000. On the other hand, debt funds are subject to market risks, and there is no assurance of capital safety. Debt funds carry two types of risk: interest rate risk and credit risk. Interest rate risk depends on the duration of the fund, with funds investing in money market instruments having lower risk and gilt funds with long maturities having higher risk. Credit risk depends on the credit ratings of the underlying securities.

Returns

Fixed deposits pay back the principal amount along with accrued interest at a fixed rate over the term, usually compounding quarterly. The interest rates on FDs have been declining, and currently, 2- to 3-year FD rates range from 5.1% to 5.4%. Debt funds, on the other hand, do not offer assured returns but are market-linked. Historically, debt funds have usually outperformed FDs of similar tenures.

Liquidity

Both FDs and debt funds are highly liquid, with no lock-in period. However, premature withdrawals from FDs may incur penalties, while debt fund redemptions within the exit load period will attract an exit load fee. Some debt funds, such as overnight funds, do not charge any exit load.

Taxation

Interest on FDs is taxed during the tenure of the investment and on maturity, with the interest added to the taxpayer's income and taxed according to their income tax rate. Debt funds offer a tax advantage, especially for investors in higher tax brackets. Short-term capital gains in debt funds (investments held for less than 3 years) are taxed at the investor's income tax slab rate, similar to FDs. However, long-term capital gains in debt funds (investments held for more than 3 years) are taxed at a lower rate of 20% after allowing for indexation benefits.

Inflation Adaptability

Debt funds have the potential to keep pace with inflation, which can erode the value of savings. For example, if you invest in an FD with a 6% interest rate and the inflation rate is 5%, the adjusted return would only be 1%. Debt funds may deliver relatively higher returns, helping to mitigate the impact of inflation.

In summary, while FDs offer capital safety and assured returns, debt funds offer potentially higher risk-adjusted returns, better taxation benefits, and the ability to keep pace with inflation. However, debt funds carry higher market risks. The decision between investing in debt funds or FDs depends on factors such as risk appetite, income tax slab, time horizon, and investment goals.

Interest rate risks

Interest rate risk is one of the two main risk factors in debt funds. The prices of fixed-income securities are inversely related to interest rate changes. This means that if interest rates go up, the price of the security decreases, and vice versa. This is called price sensitivity to interest rate change, or duration. The longer the duration of an instrument, the higher its sensitivity to interest rate changes.

Interest rate risk is temporary, as interest rate movements are cyclical. Periods of rising interest rates are followed by periods of falling rates. If you have a long investment horizon, you will be able to ride out the volatility due to interest rate changes. However, investors should be aware of the linkage between investment tenure and risk capacity. The shorter the investment tenure, the lower the interest rate risk capacity, and vice versa.

Very short-duration funds like overnight and liquid funds have very low interest rate risk, but their average returns are likely to be lower than debt funds with longer duration profiles. Short duration and medium duration funds have moderately low to moderate interest rate risk. Their average returns are usually higher than liquid funds over a sufficiently long tenure but lower than funds with even longer duration profiles. Dynamic bond funds and gilt funds have the potential to give high returns but can be quite volatile in the short term.

In the context of debt funds in India, investors should consider their investment tenure and risk appetite when selecting funds. For very short investment tenures (a few days, weeks, or months), overnight funds or liquid funds are recommended. For 1-3 year investment tenures, short-duration funds or similar funds with a duration profile of less than 3 years are suitable. For investment tenures of 3 years or more, dynamic bond funds and gilt funds can be considered.

Credit risk

However, some debt funds, known as Credit Risk Funds, invest in low-credit-quality securities. These funds are considered to have higher risks due to investing in low-quality instruments. Securities with a low credit rating tend to offer higher interest rates, and fund managers select those that might get a boost in ratings, which can positively impact the fund's Net Asset Value (NAV).

Some examples of Credit Risk Funds in India include:

• ICICI Prudential Credit Risk Fund
• HDFC Credit Risk Debt Fund
• SBI Credit Risk Fund
• UTI Credit Risk Fund
• Baroda BNP Paribas Credit Risk Fund
• Nippon India Credit Risk Fund
• Aditya Birla Sun Life Credit Risk Fund
• IDBI Credit Risk Fund
• Invesco India Credit Risk Fund
• Bandhan Credit Risk Fund

Liquidity risk

Close-ended debt funds, such as Fixed Maturity Plans (FMPs), carry high liquidity risk as they can only be redeemed on a fixed maturity date and have limited liquidity in the market. To mitigate this risk, investors should opt for open-ended debt funds, which can be redeemed at any time and offer greater flexibility.

To effectively manage liquidity risk, debt funds should employ strategies such as diversification, rigorous credit analysis, stress testing, and liquidity management tools. Diversification across different sectors and issuers helps to mitigate the impact of a liquidity crisis in a specific area. Credit analysis, including assessments of financial health, credit ratings, and industry outlook, aids in identifying potential risks. Stress testing and scenario analysis allow fund managers to gauge the fund's resilience against adverse market conditions and identify potential liquidity gaps. Additionally, maintaining a portion of the portfolio in liquid securities, setting aside cash buffers, or using asset-backed securities can enhance the fund's overall liquidity profile.

By implementing these strategies, debt funds can better manage liquidity risk, ensuring they are well-equipped to meet their obligations and maintain stability, even during challenging market conditions.

Inflation risk

Interest rate risk is closely tied to inflation. Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa. The longer the time until maturity of a debt instrument, the higher the interest rate risk. At times of high inflation, central banks may increase interest rates to curb spending and borrowing, which can trigger volatility in debt fund prices.

In India, the Reserve Bank of India (RBI) is unlikely to cut rates when inflation is high and economic activity is rebounding. A transient increase in inflation may not lead to a rate hike, as policymakers would not want to increase borrowing costs during an economic recovery. However, if inflation remains above the RBI's upper target band of 6% for an extended period, the central bank may be forced to reconsider its accommodative stance and raise the Repo rate, which could negatively impact long-term debt instruments.

To manage interest rate risk, investors can build an all-weather portfolio by investing in both short- and long-term debt funds or dynamic bond funds, which invest in a mix of short- and long-term papers to benefit from falling and rising interest rates.

Additionally, investors can consider debt funds with shorter durations and those that invest in highly-rated corporate and PSU bonds, as these can deliver reasonable returns and are less sensitive to interest rate changes.

In summary, while debt funds in India carry inflation and interest rate risk, investors can mitigate these risks by carefully constructing their portfolios, investing in a mix of short- and long-term funds, and focusing on funds with shorter durations and high-quality investments.

Frequently asked questions