Basics of Debt Mutual Funds Explained for New Investors

Debt mutual funds need not be hard-to-understand products. Here are the basics that every retail investor should know before investing or avoiding debt mutual funds! This is part one of a three-part series.

Basics of Debt Mutual Funds Explained for New Investors

Published: December 6, 2019 at 9:18 am

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Debt mutual funds are more difficult to understand and choose compared to equity mutual funds. Debt funds are also not as safe and predictable as generally considered. A little understanding of debt funds can help investors reduce risk and minimise mistakes. In this article (first of three parts), Swapnil Kendhe has tried to explain all the things related to debt mutual funds that retail investors should understand if they want to make informed decisions appropriate for their financial goals.

About the author: Swapnil Kendhe is a SEBI Registered Investment Advisor and part of my list of fee-only financial planners. You can learn more about him and his service via his website Vivektaru. In the recently conducted survey of readers working with fee-only advisers, Swapnil has received excellent feedback from clients: Are clients happy with fee-only financial advisors: Survey Results.  As a regular contributor here, he is a familiar name to regular readers. His approach to risk and returns are similar to mine, and I love the fact that he continually pushes himself to become better as you see from his articles.

Past articles by Swapnil:

Before moving to the discussion about debt mutual funds, a few important points, investors should keep in mind about the debt part of the portfolio.

  • The debt part of the portfolio is to provide stability to the portfolio, not to generate a higher return. If investors want a higher return from their portfolio, they should ideally increase equity allocation in the portfolio.
  • Employee Provident Fund (EPF), Public Provident Fund (PPF) and Sukanya Samriddhi Yojana (SSY) are the best products for debt part of the long-term portfolio for retail investors.
    Investors should use debt mutual funds in their long-term portfolios only after they have optimum used EPF, PPF and SSY. Investors can use debt funds to maintain some liquidity in their long-term portfolios.
  • If you are a senior citizen, your debt portfolio should have a Senior Citizen Savings Scheme.
  • Investors can safely use bank fixed deposits and recurring deposits if they require the amount within three years. There is no tax benefit in debt funds as against bank fixed deposits if all the amount is redeemed within three years.

Advantages of Debt Mutual Funds

Here are the benefits of debt mutual funds over bank fixed deposits, company fixed deposits and individual bonds.

  • You can deposit money and withdraw whenever you want. You can choose how much money to deposit and withdraw.
  • Unlike fixed deposits, in debt funds, you pay tax only when you withdraw. Because of the deferred tax, all the gains in debt funds are available for compounding. The impact of this over say 15 years is huge if debt funds generate the same return as that of bank fixed deposit interest rates.
  • Debt funds provide better diversification and reduce single entity risk in the portfolio.

Risks in Debt Mutual Funds

There are majorly two types of risks in debt mutual funds; credit risk and interest rate risk.

Credit Risk

Credit risk is the possibility of loss resulting from the default of bonds in debt mutual fund portfolios. To analyse the credit risk in a debt mutual fund, retail investors have no option but to rely on credit ratings.

Many investors question the reliability of credit ratings since issuers of bonds pay rating agencies for a rating that creates a conflict of interest. But credit ratings are more reliable than investors or advisers trying to do the credit analysis themselves. Retail investors and their advisers have neither adequate information nor understanding to perform extensive credit analysis of individual bonds in debt mutual fund portfolios.

Credit Ratings and their meaning

A credit rating represents the rating agency’s current opinion on the probability of default or the likelihood of the principal and the interest not being repaid in full and on time. Highest credit rating doesn’t mean a guarantee against default.

Securities issued directly by RBI and Government of India are the safest and the highest quality in the Indian context. This is because of the government’s ability to raise taxes and print money to meet its Indian rupee-denominated obligations. Government securities are not rated by the rating agencies. In debt fund portfolios, their rating is shown as SOV.

All debt instruments other than those issued by RBI and Govt of India have some degree of default or credit risk. Ratings are assigned to them by using sovereign rating of the Govt of India as a benchmark, which is assumed to have the highest rating.

The table below lists credit rating symbols and what they mean. The long-term scale is for debt instruments with an original maturity of over one year, while the short-term scale is for instruments with an original maturity of one year or less.

Long Term Rating Scale

Rating Symbol Meaning
AAA The highest degree of safety regarding timely servicing of financial obligations. Lowest credit risk.
AA A high degree of safety regarding timely servicing of financial obligations. Very low credit risk
A An adequate degree of safety regarding timely servicing of financial obligations. Low credit risk.
BBB A moderate degree of safety regarding timely servicing of financial obligations. Moderate credit risk. Lowest investment grade rating.
BB Moderate risk of default regarding timely servicing of financial obligations.
B High risk of default regarding timely servicing of financial obligations.
C Very high risk of default regarding timely servicing of financial obligations.
D In default or expected to be in default soon.

Short Term Rating Scale

Rating Symbol Meaning
A1 A very strong degree of safety regarding timely payment of financial obligations. Lowest credit risk
A2 A strong degree of safety regarding timely payment of financial obligations. Low credit risk.
A3 A moderate degree of safety regarding timely payment of financial obligations. Higher credit risk as compared to instruments rated in the two higher categories.
A4 A minimal degree of safety regarding timely payment of financial obligations. Very high credit risk and susceptible to default.
D In default or expected to be in default on maturity.

A ‘+’ (plus) or ‘-’ (minus) signs are attached to reflect a comparative higher or lower standing within each category.

Ratings are under continuous surveillance over the life of the rated instrument. Ratings can change based on changes in the business profile or financial profile of the issuer or the prospects for the industry in which the issuer operates.

Ratings of shorter duration bonds are more reliable than ratings of longer duration bonds. This is because forecasting revenue that will be dedicated to paying principal and interest on the bond being rated over the next six months or for perhaps one year, is relatively easy; but the further one predicts into the future, the more imprecise and unreliable forecasts become.

Default

Ratings are revised to default (D) at the first instance of the first rupee default. A delay of 1 day even of 1 rupee (of principal or interest) from the scheduled repayment date is considered as default. Default rating does not, therefore, imply that there are no recovery prospects.

Bonds can carry a rating in the default category regardless of recovery prospects. The rating remains in the default category until the arrears are cleared, and a track record of timely repayment of at least three months is established, subsequently. Defaulted bonds usually have some salvage value, and therefore, even when defaults occur, bonds seldom lose 100% of the value.

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Credit Ratings and yield on Bonds

The more creditworthy issuers like government, blue chip companies with little debt borrow at a lower cost. Less creditworthy issuers have to pay higher interest. Consequently, bonds with the highest credit rating will pay the lowest interest rate, while bonds with lower credit ratings pay higher interest rates. Higher the yield of the bond, the higher the credit risk.

How changes in ratings affect the prices of Bonds

When a bond is downgraded, the price of the bond declines, whereas if the rating is upgraded, the price of the bond appreciates. The change in the price corresponds to the amount required to bring the yield of the bond in line with other bonds rated at the same level. Bond prices can also change in anticipation of the rating upgrade or downgrade. Unless there is a significant risk of default, price changes because of upgrade or downgrade of bonds is small.

For bonds with high ratings of AAA or AA, a downgrade of one or even two notches is not a major cause of concern because even after the downgrade, these bonds continue to have a good margin of safety. Therefore, such downgrades do not result in serious changes in the prices of bonds. The downgrade which drops rating below investment grade or a series of downgrades should be viewed as a red flag.

Retail investors should prefer debt funds that invest most of the portfolio in SOV, AAA, AA and A1 rated debt instruments.

A high rating does not mean that the default won’t happen, but the probability of default for higher-rated papers will always be lower than those for lower-rated papers.

Interest Rate Risk

Bond prices change in response to changes in interest rates. These fluctuations in bond prices, due to changes in interest rates is referred to as interest rate risk.

The principle behind this is easy to understand.

Let us suppose you bought a 3-year bond that shall pay you 8% interest. Further, suppose at a later date, you wish to sell this bond when interest offered on the similar new bond is 10%. No buyer will purchase your bond yielding 8% when he has an option of purchasing a similar new bond yielding 10%. You must reduce the price of your bond and sell it at a price where the buyer gets a 10% yield on your bond. Likewise, you would sell the bond at a higher price if the yield on a similar new bond is 6%.

The fundamental principle is that interest rates and prices of bonds move in opposite directions. If interest rates rise, the price of the bond declines, and when interest rates decline, the price of the bond goes up. Price fluctuations are correlated with the maturity length of the bond. Higher the maturity length, higher the fluctuations in the bond price because of interest rate changes.  If interest rates rise, the value of bonds with maturities under a year changes only a little. Each additional year in maturity adds some degree of volatility.

Change in the price of a bond with 7% interest paid at maturity
Maturity If interest rates rise by 0.5% If interest rates rise by 1% If interest rates rise by 2%
1 year -0.47% -0.93% -1.83%
3 year -1.39% -2.75% -5.40%
5 year -2.30% -4.54% -8.84%
10 year -4.56% -8.88% -16.91%

The above table shows that if interest rates rise modestly, by 0.5% (or 50 basis points), the price of the one-year bond changes very little. But even that modest rise results in a decline of 4.56% for the 10-year bond. If a much sharper rise in interest rates occurs, declines become correspondingly larger.

Clearly, if interest rates go up, the holder of bonds with shorter maturities is better off than the holder of bonds with long maturities.

This phenomenon reverses if the interest rates decline.

Change in the price of a bond with 7% interest paid at maturity
Maturity If interest rates decline by 0.5% If interest rates decline by 1% If interest rates decline by 2%
1 year 0.47% 0.94% 1.90%
3 year 1.42% 2.86% 5.82%
5 year 2.37% 4.81% 9.89%
10 year 4.80% 9.84% 20.77%

Once again, the change in price is much smaller for the one-year maturity. Here, the holder of a bond would benefit from holding the longer maturity bonds because the longer the maturity, the higher the gain.

This is the reason investors anticipating a decline in interest rates invest in longer maturity bonds to realise the larger capital gains. Note that bond appreciates more in value if interest rates decline than it loses if interest rates rise.

If you hold bonds until maturity, no matter what interest rate changes occur during the life of the bond, you recover the interest and principal in full if there is no default. Therefore, as bonds get closer to their maturity, the prices of bonds move towards their maturity value.

Stay  tuned for parts 2 and 3
2: Three Key Mutual Fund Terms All Retail Investors Should Know
3: Debt Mutual Fund Categories Explained For Retail Investors

If you wish to work with Swapnil, his website is Vivektaru.

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