Decoding-Debt-Funds-July-10-2019

DECODING DEBT FUNDS
September 2019

Why Debt?
Safety
Why
Debt?
Meet
short-term
goals
Assured
returns
Cushion to
an overall
portfolio
Stability
Easy to
understand
1

Traditional - Assured
Market - linked
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19
Are You Content With Traditional Savings?
Savings Bank Account
Bank FDs/Term Deposits
Post Office Savings Schemes
13%
12%
11%
10%
9%
8%
7%
6%
5%
4%
Easing trend of bank FDs returns*
Public Provident Fund
Government Bonds
Corporate Bonds
Debt Mutual Funds
Potential to generate higher returns
Money market instruments
*Source: RBI
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Know The Basics
3

Know The Basics
What is bond?
Bond Issuer (Borrower)
Corporate, Institution or
Government
Fund
Bond
(Promise to repay loan + Interest)
Bond Holder (Lender)
Investor
Principal
Original investment amount or
amount of money borrowed
Coupon
Fixed interest payment on a
periodic basis
Maturity
Date on which bond expires
assuming all payments are paid
Rs 1000 Rs 70 Rs 70 Rs 1000 + Rs 70
Year 1 Year 2 Year 3
4

Know The Basics
What is yield?
Annualized rate of return from a debt instrument
Yield
Current Yield
Yield To Maturity (YTM)
Single year return earned on the
price paid for a bond
Total returns if a bond is held
until maturity
Components
• Coupon
• Price
Components
• Coupon
• Price
• Maturity amount
• Time to maturity
YTM is more accurate than Current Yield
5

Know The Basics
Why the inverse relationship between bond price and yield?
Illustration
Bond’s par value: Rs 1000
Coupon rate: 7%
Interest rate change
Change in bond’s value
Rise
Fall
8%
7%
6%
> Rs 1000
Rs 1000
< Rs 1000
Premium
Discount
When interest rates rise, bond prices fall, and vice-versa
6

QUIZ – Knowledge Check
The interest paid to the investor who bought the bond is?
A. Dividend
B. Coupon
C. Par value
If market interest rates rise, then the price of a bond will _____
A. Rise
B. Fall
C. No Change
7

Decoding Debt Funds
8

Decoding Debt Funds
Where they invest?
Objective - Generation of steady income
Where they invest?
Corporate Market Money Market Gilts
Corporate Bonds Certificate of Deposits Government Securities
PSU Bonds Commercial Papers State Development Loans
Debentures Repos Treasury Bills
Call Money
Cash Management Bills
9

Decoding Debt Funds
Debt Funds vs Traditional Instruments
Debt Funds
Traditional Instruments
Liquidity*
High
Low
Lock-in period*
No
Yes
Tax Efficiency
High
Low
Risk
Low to Moderately High
Low
Returns
Variable
Assured
*Applicable to only open ended funds
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Decoding Debt Funds
Myths vs Reality
MYTHS
Provide assured returns
REALITY
Provide market-linked returns
Rise in interest rates means rise in
returns
Capital is guaranteed
Bond prices and interest rates are inversely correlated
Capital is exposed to interest rate risk or credit risk
NAV can never fall
NAV may rise or fall depending on underlying
security prices
All corporate bonds have similar risk
Differs based on credit ratings
Government bond funds carry no risk
Although no credit risk, but are exposed to interest rate risk
11

Decoding Debt Funds
Why invest in debt funds?
Diversification
Stability
Liquidity
Returns
Tax efficiency
Convenience
Cushion to a
portfolio from
downside risk
arising from equity
funds
Historically proven
to have moderate
to low volatility of
returns
Investments can
be redeemed in
part or as a whole
any time
Accrued interest
plus capital
appreciation
Indexation benefit
provides better
post-tax returns
Use systematic
features to meet
different goals
12

Risks Associated
with Debt Funds
13

Maturity
Risks Associated With Debt Funds
Interest Rate Risk / Duration Risk
Interest Rate risk is the risk of changes in bond prices due to fluctuation in interest rates
Bond prices and interest rates move in opposite directions
Long
Short
Medium
Low
High
Interest Rate / Duration Risk
Duration Risk
Price fluctuate more of longer maturity bonds and less of shorter maturity bonds
due to interest rate changes
14

Risks Associated With Debt Funds
Interest Rate Risk / Duration Risk
Measuring Interest Rate Risk
Modified Duration
Measures the sensitivity of the price of a bond due to change in interest rates
Modified duration of 5 years
Interest rates rise by 2%
Price of a debt security
reduces by 5*2 = 10%
15

Credit Ratings
Risks Associated With Debt Funds
Credit Risk
Risk that the issuer will not pay the coupon and/or maturity proceeds
Debt funds mostly
invest here
AAA
AA-
AA
AA+
A-
A
A+
BBB
BB
B
C
D
Low
Credit Risk
High
Downgrade in credit rating can negatively impact the NAV
16

Risks Associated With Debt Funds
Liquidity Risk
Risk of not being able to convert an asset quickly into cash
Lower the demand for a security
Higher the demand for a security
Higher the Liquidity Risk
Lower the Liquidity Risk
Downgrade in credit rating may result in higher liquidity risk
17

QUIZ – Knowledge Check
Debt funds provide assured returns
A. True
B. False
The risk of changes in bond prices due to fluctuation in interest rates
A. Credit risk
B. Interest rate risk
C. Liquidity risk
18

How Does a Debt
Fund Work?
19

How Does a Debt Fund Work?
Popular Investment Strategies
Accrual
Duration
Objective
Generate steady returns by investing
in bonds
Objective
Generate returns by actively
managing portfolio duration
Accrual
Investments
generally
held till
maturity
Accrual
Total Returns
Capital Gains
Investments
are actively
managed
Capital Gains
20

How Does a Debt Fund Work?
Popular Investment Strategies
Features Accrual Duration
Interest Rate Risk Low to Moderate Moderate to Higher
Credit Risk Moderate Moderate
Active Duration Management Not Required Required to Some Extent
Volatility Lower Higher
Purpose Regular Income Tactical Income by timing the market
Returns Composition
Interest accrual (High)
Capital Gains (Low)
Interest accrual (Low)
Capital Gains (High)
21

Different Products
for Different Needs
22

Classification of Debt Mutual Funds
Based on Investment Horizon
ACCRUAL
DURATION
Overnight/
Liquid
Ultra
Short
Duration
Low
Duration
Money
Market
Short
Duration
Medium
Duration
Medium
to Long
Duration
Long
Duration
Investment Horizon
Short (Few Days, few months, <3 years)
Long (>3 years)
23

Credit Risk
Low High
Classification of Debt Mutual Funds
Rating and Objective based
RATING BASED
Mix of AAA and /or lower rated bonds
Mix / Managed Credit
AAA and Government bonds
High Credit
OBJECTIVE BASED
DURATION
ACCRUAL
Gilt
10 Year Constant Duration Gilt
Banking & PSUs
FMPs
Floater
Invest atleast 80% in government securities
Invest in securities of banks, PSUs and PFIs
Close-ended fund
Invest in floating rate securities
24

Lower
Higher
Return
Debt Funds by Investment Goals
Few Days to
Few Months
Few Months
to 1 Year
1 to 3
Years
3 to 5 Years
5 Years and
Above
Emergency funds,
Surplus money,
Alternative to
savings account,
Household
expenses
Mobile phone, Household
electronics, Advance tax
planning
Vacation,
Rebalanc
ed funds
from
equity
Vehicle, House
Education,
Marriage,
Retirement
Overnight
Liquid
Ultrashort
Duration
Low
Duration
Money
Market
Short
Duration
Medium
Duration
Medium
to Long
Duration
Gilt
Long
Duration
Lower
Risk
Higher
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QUIZ – Knowledge Check
Identify a good fund to park money for less than 1 month
A. Gilt
B. Liquid
C. Long Duration
A high credit fund will comprise of which type of securities?
A. Government securities and AAA rated bonds
B. AAA and AA rated bonds
C. AA and A rated bonds
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QUIZ – Knowledge Check
Long Duration Funds generate return from only Coupon Income of the
underlying securities
A. True
B. False
_______ Funds invest in securities with below AAA ratings and spot opportunities
through rating upgrades
A. Credit Risk
B. Overnight
C. Gilt
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Choosing the
Right Debt Fund
28

Choosing the Right Debt Fund
1.
Match the fund category with your investment goal horizon
2.
Choose a fund which matches your risk appetite
3.
Choose a fund with a good track record
4.
Choose a fund with a well-diversified portfolio
5.
Consult a financial advisor
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Tax Efficiency
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Indexation Benefit
• Indexation allows to adjust gains after taking inflation into consideration
• Helps to earn better post-tax returns if held for more than three years
Indexation benefit
Traditional Debt Products
without indexation benefit
Debt Fund
with indexation benefit
Initial Investment @ 8% for 1203 days (> 3 years) (A) 100,000 100,000
Amount at Maturity (B) 128,873 128,873
Indexed Cost* (C) NA 113,780
Capital Gains = (B-A) for (I), (B-C) for (II) 28,873 15,093
Tax Rate** 31.20% 20.80%
Taxable Liability 9,008 3,139
Post Tax Amount 119,864 125,733
Post Tax CAGR 5.65% 7.19%
Assumption - Investment was done in FY15-16 and redeemed in FY19-20. Hence the investor got the benefit across 5 financial years.
Note - The above illustration is hypothetical and is only for the purpose of explaining the concept of indexation benefits for Resident Individual / HUF. Return calculation is assumed and actual returns may
vary. *. For arriving at the indexed cost of acquisition, we have assumed that the investment is done in FY15-16 and redeemed in FY 19-20. CII is: FY15-16: 254, FY16-17: 264, FY17-18: 272, FY18-19: 280
and FY19-20: 289 ** Highest tax rate of 31.20% is taken into consideration, the tax rate is 20.80% in case of indexation benefit. 0% surcharge rate is considered for the above illustration. Surcharge in case
of Individual/HUF is levied at rate of i) 10%, where total income exceeds Rs 50 lakhs but does not exceed Rs 1 crore, ii) 15%, where total income exceeds Rs 1 crore but does not exceed Rs 2 crores , iii)
25%, where total income exceeds Rs 2 crores but not exceed Rs 5 crores, iv) 37%, where total income exceeds Rs 5 crores.
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Systematic Withdrawal Pan
• Allows to withdraw a fixed amount at regular intervals
• Provides tax efficiency vis-à-vis bank FDs
Illustration
Goal
Monthly income of Rs 10,000 from
corpus of Rs 15 lakhs
Options
1) SWP from a debt fund growing @ 8% p.a.
2) Monthly interest from Bank FD @ 8% p.a.
BANK FD
SWP
Period
Interest from
FD (A)
Tax Rate*
Tax Amount
(B)
Net Interest
received (A-B)
SWP
Amount (A)
Tax Amount
(B)
Effective Tax
Rate* (A/B)
Net Cash
Flow
1 Year 120,000 31.20% 37,440 82,560 120,000 1520 1.27% 118,480
3 Years 360,000 31.20% 112,320 247,680 360,000 12345 3.43% 347,655
5 Years 600,000 31.20% 187,200 412,800 600,000 19883 3.31% 580,117
SWP in a debt fund can be more tax efficient than Bank FD.
Note - Above illustration is only for the purpose of explaining the difference in tax computation between systematic withdrawals and banks FD. Unlike banks FD, debt funds do not provide assured returns.
*0% surcharge rate is considered for the above illustration. Surcharge in case of Individual/HUF is levied at rate of i) 10%, where total income exceeds Rs 50 lakhs but does not exceed Rs 1 crore, ii) 15%,
where total income exceeds Rs 1 crore but does not exceed Rs 2 crores , iii) 25%, where total income exceeds Rs 2 crores but not exceed Rs 5 crores, iv) 37%, where total income exceeds Rs 5 crores.
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QUIZ – Knowledge Check
Indexation allows to adjust gains after taking ___________ into consideration
A. Maturity
B. Credit rating
C. Inflation
Which mutual fund feature allows you to withdraw a fixed amount at regular
intervals?
A. SIP
B. SWP
C. STP
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In a Nutshell
34

Debt Funds – 7 Key Takeaways
1
Potential to earn higher returns with reasonable safety and liquidity
2
Tax-efficiency vis-à-vis other traditional debt avenues
3
Diversified portfolio of money market, corporate and government securities
4
Two strategies – Accrual (regular income) and Duration (capital appreciation)
5
Variety of fund choices that can be mapped as per goals
6
Must be mindful of Interest rate risk, Credit risk, and Liquidity risk
7
Fund’s performance track record plays an important role in choosing a fund
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