Over the past week, I have received several questions about debt funds. I am reproducing a few here for your benefit and learning.
#1 What is the difference between debt funds and liquid funds?
Debt / Fixed Income is an umbrella category / asset class just as equity is. Now within equity, you have large, mid, small cap, sectoral funds, value funds, etc.
In case of debt funds, you have different categories such as overnight, liquid, ultra short duration, low duration, Gilt, Credit Risk, Corporate Bonds, etc.
Overnight funds hold investments that mature in 1 day. Liquid funds have residual maturity upto 90 days. However, they still are a category under debt funds.
Certain other categories are distinguished on the basis of the duration of their portfolio. An Ultra Short duration funds maintains it within 3 to 6 months, while a medium term bond maintains between 3 to 4 years.
The taxation for all debt funds remains the same.
Read more: 10 things to know about debt mutual funds
#2 How can an Ultra short fund invest in something that has a 2, 5 or 7 year maturity? Aren’t they supposed to maintain that within 3 to 6 months?
There is a bit of technicality at work here. As per SEBI norms, ultra short funds need to maintain a Macaulay Duration (MD) of 3 to 6 months. The maturity dates of some of the individual investments in the portfolios can be later than 6 months. As long as MD is within range, the portfolio can be constructed using various maturity profiles.
It goes without saying though that most holdings will have a lower maturity date. Some maturity options are managed using various techniques including put / call options.
So, when you read Ultra Short Fund funds restriction of 3 to 6 months, it is not about the maturity of the bonds but about the Duration.
#3 This duration vs maturity thing is so confusing. What is Macaulay duration?
In layman terms, Macaulay Duration (MD) measures the time in which the cash inflows from the investment will be equal to the price paid. It is a sort of payback period.
Maturity refers to the time when the investment becomes due for final payment of principal borrowed. For a portfolio of various investments, we calculate the average maturity.
Now, most debt investments involve a payment of coupon or interest. Since this is a cash flow accruing to a fund, the payback from the fund is likely to be lesser than the actual maturity.
If the interest rate is high, the MD will be much lower, since higher cash flows via interest payments lead to reduction in payback period.
Duration is also used to measure the interest rate sensitivity of a bond or debt fund. So, if the duration is 0.5, then for every 1% change in interest rates, the value of the bond or debt fund will change by 1% in the reverse direction. (There is negative correlation between interest rates and bond prices)
Remember the above is only a layman understanding. There is material you can search to study this concept more.
#4 How can debt funds invest in low rated securities such as A, A-, etc.? Does SEBI even allow that?
Well, SEBI only specifies the duration criteria for the funds and not really the credit risk / ratings that they should adhere to. You must know that all ratings including Sovereign, AAA to BBB are considered investment grade. The difference between AAA and A- is that one is top rated and other is low rated, but both are investment grade.
Within the portfolios, managers can choose credit risk. Whether they want to invest in top rated debt (AAA) or somewhat lower rated but still investment grade, so as to chase higher returns. For example, Franklin India Ultra Short Bond Fund.
Exceptions are Corporate Bond funds, which are required to maintain at least 80% in AA or above rated securities and Gilt funds invest their corpus in government securities only.
Funds like Quantum Liquid or Parag Parikh Liquid focus on protection of capital and invest in Govt Bonds and top rated PSUs only, thus there is no credit risk. Because liquid funds can have investments with 90 days residual maturity, the sensitivity to change in interest rates is also low. Thus they make for relatively safer investments.
#5 Why does my debt fund value show a loss? I thought they were as good as FDs?
One of the key differentiators between FDs and debt funds is the daily mark to market. In debt funds, this is reflected in the daily NAVs so.
This process requires valuing each of the securities held in the portfolio. These valuation norms take into account credit rating changes and interest rate changes. As mentioned before, debt fund prices are sensitive to interest rate changes. In fact, there is an inverse relationship between interest rates and bond prices.
Suppose there is Bond ABC with a face value of Rs. 100 and a coupon rate of 10%. The duration (not maturity) of the bond is 1 year.
Now, if the market interest rate moves up by 1%, the price of the bond will fall by 1%, thus taking it to 99.
So, when interest rates/ yields go up, your fund / listed bond may see a drop in value.
The vice versa is also true.
Another reason that you can see a loss is when one of the holdings of the debt fund suffers a credit rating downgrade or defaults. In that case, again as per SEBI norms, the value of the particular holding will be reduced in value or completely written off. This will show up in the NAV as a loss.
No such thing happens in an FD where everything if fixed along with a 5 lakh guarantee from the government.
Have any more questions? Do send across.