All you wanted to know about Debt Funds

Debt funds invest in loans i.e. they give loans and collect interest*.

These loans can be to companies in the form of corporate bonds, to central and state governments in the form of government bonds, to banks in the form of commercial paper etc.

Types of Loans (Bonds)

Loans are characterised by two factors:
a) duration of the loan, and
b) credit-worthiness of the borrower

Interest rates on loans are determined by the above two factors and
c) the base rate set by the RBI and banks

It is similar to when a friend asks you for money. You think about how likely he is to return the money (credit-worthiness) and how long is the money to be given for (duration). These two determine whether or not you will lend the money and at what interest. For a short duration to someone close to you, you might not charge any interest whereas if the same person wants the money for a few years you might want him to at least give you the FD rate (your base rate).

Higher Interest Rate = Longer duration or riskier borrower or higher RBI rates

Similarly longer duration loans typically carry a higher interest rate and so do loans to less credit-worthy borrowers. The lender will demand a higher rate of interest when lending money to someone with a lower credit rating because there is a risk that the person may not pay back all of it.

So you can have loans that are (ultra short term, short term, medium term, long term) given to (government, corporate, bank deposits). Almost all sorts of combinations exist and their risk-reward equation increases with duration and decreases with credit-quality of the borrower.

Debt Mutual Funds

Debt Mutual Funds are characterised by the type of loans they give/invest in.

A Debt Mutual Fund that primarily invests in loans that are of short, medium or long duration will be categorized as a Short Term Debt Fund, Medium Term Debt Fund or Long Term Debt Fund respectively. Additionally if the Mutual Fund only invests in government bonds then it will be called a Gilt Fund.

A more complete list of Debt Mutual Funds categories is presented later below.

Risk-Returns tradeoff in Debt Funds

Did you know that it is possible to make a loss when you invest in Debt Funds?

Most of us are aware of the risk-reward trade-off with respect to equity markets and equity Mutual Funds. Equity markets are risky/volatile hence they give higher returns as compared to an FD to those who bear (and survive) that risk.

Similar risk-reward trade-offs exist in debt markets and debt Mutual Funds too (although the magnitude is lower). As they say, there are no free lunches.

The total returns of a debt fund comprise of the following:

  • Interest earned on invested securities
  • Capital gains - due to changes in the interest rates. Bond prices go up when interest goes down and vice versa.

Higher returns = higher risk even in Debt Funds

If the returns from a particular Debt Fund are higher than the current FD rates, that is because the fund is taking at least one of the two risks below:

Credit Risk

Loans given to corporates will be riskier and of higher interest rate than those given to the government. Within corporates also different corporates have different credit-worthiness and there is an entire spectrum (think Tata vs Kingfisher Airlines). Loans given to companies with poor credit rating will be even riskier and will correspondingly bear an even higher interest rate because there is a risk of default or delayed payments.

Duration Risk

Longer duration means less certainty on your repayments. Even though the credit rating of the borrower may be good today, it can change over time and you would be stuck with a bad loan then (this is how banks end up with NPAs).

Another factor that introduces risk with longer term loans is that you get locked-in with the interest rate at the time of making the loan (like an FD).

If in future the general interest rates increase, you will still be stuck with your lower interest bearing loan. In other words, the net worth of your loan will go down as compared to the new loans of same amount being issued at current interest rates.

On the flip side, if the general interest rates decline, you would be happily 'stuck' with your higher interest bearing loan whose net worth value will go up compared to the new loans being issued at current interest rates.

So the value of a longer duration loan varies a lot with changes in interest rates set by RBI from time to time thus bringing volatility.

The extra return on higher duration loans is a compensation of bearing these two aspects of duration risk.

For shorter term loans this is less of a problem since the loan is valid for only a short period and after that you will have to switch to giving a new loan at the new interest rates (like short term FDs) so the impact is limited.

List of Debt Mutual Funds categories

Here is a list based on popular categorisation:

Categories and returns taken from VRO as on 16/05/2017; duration and risk information for various categories taken from HDFC Debt Report

As you can see, the difference between the safest debt funds (Liquid Debt Funds) and the ones with the highest volatility/risk (Gilt Long Term Debt Funds) is positive although not by much - about 1.4 % pa.

Why does Goalwise recommend only Liquid/Ultra/Short Term Debt Funds and not Long Term or Gilt Debt Funds?

Liquid, Ultra Short Term or Short Term Debt Funds seem to offer the best alternative to FDs without compromising on the safety.

Long Term or Gilt Debt Funds give slightly higher returns but are more volatile in nature.

In a recent example of this volatility, even a 5-star rated long term fund - SBI Magnum Gilt Fund - Long Term Plan is down over the last 5 months (~ Dec 2016-May 2017), whereas short term debt funds like Birla Short Term Fund or even a medium term fund like Reliance Medium Term fund are all up 2-3% for the same time period.

As investors we expect debt to give stability to our portfolio and not give negative returns. Long Term Debt funds can give negative returns for an entire year also - as they did in 2009 when they lost about 10-15%!

Long term debt funds do give higher returns during interest rate declines but over a complete cycle of say last 10 years, their returns have been around 9-9.5% - not much different from that of short term funds ~ 8.5%. This difference is not enough to justify the volatility that long term debt funds bring to your portfolio hence we don’t recommend long term debt funds.

Read More: 5 Reasons why I prefer Debt Mutual Funds over Fixed Deposits