If you want to avoid the market fluctuations of Equity Stocks and are risk-averse, consider investing in debt-oriented mutual fund schemes.
Debt funds invest in either listed or unlisted debt instruments, such as Corporate and Government Bonds at a certain price and later sell them at a margin. The difference between the cost and sale price accounts for the appreciation or depreciation in the fund’s net asset value (NAV). Debt funds also receive periodic interest from the underlying debt instruments in which they invest. In terms of return, debt funds that earn regular interest from the fixed income instruments during the fund’s tenure are similar to bank fixed deposits that earn interest. This interest income gets added to a debt fund on a daily basis. If the interest payment is received, say, once every year, it is divided by 365 and the debt fund’s NAV goes up daily by this small amount. Thus, a debt scheme’s NAV also depends on the interest rates of its underlying assets and also on any upgrade or downgrade in the credit rating of its holdings.
Market prices of debt securities change with movements in interest rates. Let’s assume, your debt fund owns a security that yields 10 % interest. If the interest rate in the economy falls, new instruments issued in the market would offer this lower rate. To match this lower rate, there would be an increase in the prices your fund’s underlying instruments as they have a higher coupon (interest) rate. As a result of the increase in the debt instrument’s value, your fund’s NAV, too, would increase.
A few major advantages of investing in debt funds are low cost structure, stable returns, high liquidity and reasonablesafety. Debt funds also score on post-tax return. Dividends from debt funds are exempt from tax in the hands of investors.The mutual fund, however, has to pay a Dividend Distribution Tax, which is currently 28.325 per cent in case of individuals or Hindu undivided families. While long-term capital gains from debt funds are taxed at 10 per cent without indexation and 20 per cent with indexation, short-term capital gains taxes are levied according to the income-tax bracket one belongs to.
Thus, debt funds can be a good alternative to investors for achieving their financial goals if they do not intend to bear risk involved in equity investments.
Growth Option vs. Dividend Option
As mentioned above, dividend from mutual funds is tax free in the hands of the investors, but the same is subject to Dividend Distribution Tax (currently 28.325 %), which indirectly decreases the net returns. Hence, dividend payment or dividend reinvestment option gives better post-tax returns, to those who are in the highest tax bracket. However, for those in lower tax slabs, growth option could be more tax-efficient. In short, one should choose the appropriate option depending on the tax bracket.
There’s no fixed rule as to who should invest in debt funds. It depends on the requirement of investors. Different types of investors invest in different types of debt funds. For instance, if someone wants to park his emergency funds, he can go for liquid funds.
As a thumb rule, 3-6 month’s household expenses can be one’s emergency fund depending on the age. Roughly the amount that gives you the confidence to combat emergencies in your household should be enough. Anything more can actually affect your investment portfolio. Those in their 20s and 30s might need more, so garner funds for about six months’ expenses, whereas those nearing retirement might not need much as they would have built up their reserves. The amount you save for an emergency depends ultimately on what makes you comfortable.
If you are the risk-averse type, then you might prefer a large fund of, say, a year’s salary. If, however, you are the living on-the-edge type, then six months’ salary might suffice.
For those planning to buy a home after 2-3 years, investing in a combination of both long- and short-term debt funds might be a good idea. Also, a debt fund can be used in the overall portfolio for diversification across asset classes. Debt Funds can also be used for portfolio de-risking when you are nearing your financial goals.
Remember, it is the asset allocation (government securities, corporate debt and marketable securities) that largely determines how a debt fund’s NAV will move. A close look at a fund’s portfolio composition will give you an idea of the expected returns, risks and liquidity. So, when picking a fund, watch out for a few things.
One, check the average maturity of the fund’s portfolio as this has a bearing on your returns. The lower the average maturity period, the lower the fund’s volatility and your returns. On the other hand, a fund with a long maturity period is likely to be more volatile, but the returns are likely to be better.
Two, make sure the fund’s portfolio is reasonably liquid. A large percentage of corporate debt in the portfolio does not bode well in the short term, as it is relatively less liquid. If the fund faces redemption pressure, it would be forced to sell these securities at a discount, lowering the NAV. Also, be wary of funds that hold a lot of unrated and unlisted debt.
Three, avoid schemes with small corpuses. That’s because funds don’t disclose if there are any investor who owns a substantial chunk of outstanding units. If there are such investors and they decide to redeem their holdings, the fund could be forced to sell holdings below the market rates.
Four, the best tool to capture the interest rate sensitivity of a debt fund is modified duration. It tells you how much the price of a bond would move if interest rates move up or down by 1 per cent. The higher the modified duration, the greater will be the impact of an interest rate change. Mutual funds give you access to all the information in their offer documents and other periodic disclosures for you to make an informed decision. It is then up to you to take the investment decision and sign the form, or channel the money to suit your financial needs.
Also, you should understand how interest rate movements, credit ratings and liquidity affect a debt fund’s performance. Theoretically, if interest rates rise, the NAV of a debt fund should fall. That’s because Bond prices move in the opposite direction as interest rates. A fall in bond prices leads to a decline in a fund’s NAV. The opposite would happen if interest rates fell. Of course, in an imperfect and illiquid market like India, this might not happen to the entire extent. Moreover, if some bonds held by your debt fund are upgraded, their prices would rise, leading to a drop in yields. That would, of course, increase your fund’s NAV. So, one should be prepared for fluctuations in one’s fund’s NAV. Even Gilt Funds (which invest only in government securities) that are advertised as the safest available investments, can witness sharp fluctuations in their NAVs. That’s because prices of government securities are a function of various economic factors, including interest rates, macroeconomic data and liquidity in the banking system. When these change, so do the Gilt Fund’s NAV.
Debt funds invest in a number of debt instruments, all of them having a varying maturity. That’s where the average maturity comes handy. As the name suggests, it basically indicates the average maturity of all the securities in a portfolio, giving you the freedom to compare.
Average maturity thus gives you a quick glimpse into the sensitivity of the bond to interest rates. Funds with higher average maturities tend to be more volatile in the short term since their objective is to deliver higher returns over the long term. Simply put, a fund with an average maturity of 5 years is definitely more volatile in the short term than a fund with an average maturity of say 9 months. That’s because in the shorter term there is reasonable surety on the receipt of the coupon income.
So matching your investment horizon with the average maturity is always a good idea. But remember, an average maturity of say 4 years doesn’t necessarily mean that you have to hold it for 4 years. But it definitely indicates is that you can expect to get optimal returns, given the interest rate environment, over 4 years.
Exit load isan effective mechanism that prompts investors to stay invested through the desired holding period. This ensures that investors, who move in and out of the fund and take away accrued gains during momentary positive market movements, do not short-change diligent investors who stay invested for the entire course.
Choosing funds for children’s education
When it comes to taking the mutual fund route for your children’s future, the basic rules of the game are essentially the same as that for any long-term goal. But here, merely investing will not work. You need to be cautious about the risk management of your corpus, especially when your child is close to going for his higher studies. Along with investing, making the money available at a time when your child needs it is equally important. So, here debt funds play a vital role. With time on your side, investing in equity has many ad vantages. But you need to keep a close eye on the market once you are less than three years away from your goal. One needs to de-risk the portfolio when you are nearing your targets to ensure that the gains you have earned are not wiped out. In other words, as you near your target, start shifting from equity to debt so as to secure your gains.
When moving away from high-risk options, you could choose to move into liquid and short-term debt funds or slightly riskier funds in the debt space, such as bond and gilt funds, depending on the interest rate scenario prevailing at that time. For instance, if the interest rates are falling, short- to long-term bond and gilt funds would bode well. But if interest rates remain flat or move upwards, stick to liquid funds; they are safer than the rest of the debt schemes, if not the safest of all financial instruments, and they would still earn you more than your savings bank account.
The ideal way to build an adequate corpus for your child’s future is to go step by step – through Systematic Investment Plan or SIP. The sooner you start, the better. Of course, you also need to stop along the way occasionally to make sure things are going as planned. The closer you get to your investment goal, the more careful you need to be that you are not taking a wrong turn.
Role of debt fund in retirement portfolio.
As you age, lighten your equity funds holdings marginally; the aggressive investor should cut equity in his portfolio from 80 per cent to 70 per cent, and the conservative investor from 60 per cent to 40 per cent. With about 15 years away from retirement, you should start playing steady and balance your exposure to debt and equity. For instance, the conservative investor may choose a 10-20 per cent higher debt allocation. On the debt side, you may look at floating-rate funds and fixed maturity plans. Balanced funds are another option for the semi-aggressive investor to strike a debt-equity mix.
Strategy - Follow the life stage approach to investing while saving through mutual funds for retirement needs. As you age, keep balancing the allocation between equity and debt.
With around 10 years away from your retirement, your priority should be to ensure the safety of your accumulated wealth. Plan out the de-risking strategy and wait for an opportune time to migrate your money from volatile equity to safer debt. By the time you are 1-2 years away from retirement, a large portion should have been moved away from equity into debt funds.
Acquiring a house
Investing in mutual funds not just helps in creation of wealth but also helps in creating assets. They play an important role in helping one build the biggest asset of life—a home of your own.
Paying the equated monthly instalments (EMIs) has come reasonably within the reach for most families, especially when both partners work. However, accumulating a big lump sum to pay the down payment on the house remains the biggest obstacle. This is where mutual fund schemes come in handy. All those who live on rent constantly wonder why they should be throwing their hard-earned money out as expenses, when they could use it to buy a house and create an asset. That is more so now, when property prices have, perhaps, settled down and when home loans are easily available as housing finance companies are offering easy loans to customers. If you are contemplating buying a house in 2-3 years, mutual fund schemes can help you accumulate the money, especially the down payment for the loan.
Generating funds from friends, relatives or pawning gold might not be the best ways to arrange the money. Plan early to avoid depending on such sources as far as possible. If you feel that your personal circumstances are right for buying a home, start by creating a savings plan for your down payment. Get an idea of the purchase price and the EMI payments that you can afford. Estimate what you’ll need for margin money, which is usually 20 per cent of the home price. Thereafter, calculate how much you must save every month.
Where to invest
If the time horizon is less than a year or just a year away, it is better to stash funds in a money-market or liquid fund. The volatility in these funds is the least as exposure to equities is non-existent. The idea is to preserve the capital and not take undue risks with the savings. Choose at least two or three debt funds for diversification and start saving through the systematic investment plan (SIP) process. Ideally, keep the portfolio tilted towards debt even if you are taking a bit of risk.
Strategise your moves.
Remember, even debt funds suffer from interest rate risk. So, ensure that you shift to less volatile debt funds, such as short-term debt funds, at least two years before reaching your goal. With just one year away from your goal, shift your savings completely into a liquid fund. Your small savings every month might not cramp your household budget, but they will still create a lump sum big enough to meet your down payment needs for a home.
As shown in the chart below, there is wide choice, to invest as per investor’s risk-return profile and life stage. Note that the choice of schemes is illustrative. For instance a young investor at the start of her career has a higher risk appetite and time horizon and, thus, she can look at investing in long-term debt categories such as monthly income plans, gilt funds, long-term income funds and credit opportunity funds. As the investor’s age advances, the risk-taking capacity may diminish. Hence, investment in shorter maturity schemes such as fixed maturity plans, liquid funds and ultra-short term debt funds may be considered. The shorter lock-in period ensures that funds can be accessed to meet both expected and unscheduled financial obligations.
As can be seen from the table below, a small portion of equity in the portfolio could enable investors to generate inflation adjusted returns in the medium to long term. CRISIL-AMFI Monthly Income Plan Index which has up to 30% of the portfolio in equity has been used for the inference.
|Liquid Funds||Low duration funds, with portfolio maturity of less than 91 days.||A good alternative to savings bank account; potential to offer higher post-tax returns.|
|Ultra short-Term Bond Funds||Low duration funds, with portfolio maturity of less than a year.||Ideal for parking short-term surplus money; also offer slightly better returns than liquid funds.|
|Short-Term Income Funds||Medium duration funds where portfolio maturity ranges from one year – three years.||Investors with a horizon greater than one year can benefit from these funds in a rising interest rate scenario.|
|Fixed Maturity Plans (FMPs)||Passively managed close-ended funds, where investments are held to maturity.||An alternative to FDs with investment horizon of over three years.|
|Long-Term Income Funds||Medium to long duration funds with portfolio maturity between three and 10 years.||Suitable for investors with a longer investment horizon. These funds benefit when interest rates fall as bond prices (NAVs) and interest rates are inversely correlated.|
|Gilt Funds||Medium to long duration funds with portfolio maturity between three and 20 years and negligible credit risk,||The gilt portfolio of these funds does not carry credit risk, only interest rate risk. These funds benefit the most in a falling interest rate environment.|
|Monthly income Plans (MIPs)||Medium to long duration funds normally with exposure of less than 30% to equity.||Ideal for investors who are looking for returns better than traditional debt instruments and do not want higher exposure to equities. The tilt towards debt ensures stability of income and the equity portion provides appreciation when stock markets rise.|
|Capital Protection Oriented Funds (CPFs)||Follow an investment structure which seeks to protect the initial investment from capital erosion. These type of scheme offered is “oriented towards protection of capital” and “not with guaranteed returns”. The orientation towards protection of the capital originates from the portfolio structure of the scheme and not from any bank guarantee, insurance cover etc.||CPFs have a small equity component which gives risk-averse investors an opportunity to participate in the equity markets without worrying about erosion of the principal which is protected. CPFs are also rated by credit rating agencies.|
|Dynamic Bond Funds||Actively managed by reducing the portfolio maturity in a rising interest rate environment and increasing portfolio maturity in a falling interest rate environment.||Ideal for investors who may find it difficult to judge the interest rate movement. These funds help investors minimize interest rate risk as they offer flexibility to alter the portfolio maturity according to the interest rate scenario. Maturity is longer when interest rates fall and shorter when interest rates rise.|
|Credit Opportunity Funds||These funds purchase bonds in lower rated bonds to generate higher returns/yields.||Suitable only for investors with a profile to take higher risk as investing down the rating spectrum adds to the risk of the portfolio.|
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