What exactly is a debt mutual fund? How is it different from an equity mutual fund?
Amol Joshi: Equity funds are popular and hence well understood by investors. Equity funds invest into equity stocks and shares. Similarly, debt mutual funds invest into debt securities though debt securities could be an instrument called a CD, that is certificate of deposit issued by banks or more commonly a debt mutual fund or a fixed income mutual fund is a mutual fund that invests into various debt instruments like CDs is one we discussed and bonds issued by various issuers. Those various issuers could be government issuers, there are government bonds.
Then, there are PSU, public sector units or public sector undertakings which issue bonds and there are bonds issued by private corporate companies and private corporate groups as well. So, the debt mutual fund is very different from equity and it can form a part of investors’ portfolio and provides very important and crucial asset allocation to investors’ portfolios.
Help us understand who must opt for a debt mutual fund and who would this instrument be a suitable option for? Who is this the right fit for?
Amol Joshi: I would say that debt mutual funds should be used by any and every type of investor. Typically, there are some rules of thumb where it is said that a debt mutual fund is typically useful when you have an investment horizon that is spanning a few weeks or few months or something that is not really medium term or long term.
Over a medium and long term, they are better off investing into equity funds. As I mentioned, that is a rule of thumb. It is not necessary that it works all the time. Equity investors also can use debt mutual funds. How? Typically, in your assessment, if the market is trading at premium valuations and you have a lump sum investment to be made, you would not be wanting to invest the entire corpus at one go. What you would typically do there is invest into a liquid fund.
A liquid fund is nothing but one type of a debt or fixed income mutual fund and from there you do STP, that is systematic transfer plan, that is just one example how even an equity investor would benefit by using debt mutual fund, something like liquid fund. So, the next question would be how can one benefit? See, if you want to take a staggered entry into markets, you would probably do a quick three-month, six-month kind of SIP from your bank account. However, most bank accounts, saving accounts will fetch you 2.5-3% kind of return. As against that, liquid funds are likely to generate much better returns, something very, very close to 7% or so as things stand now, that is how equity investors can benefit. Other than that, any goal, financial goal that is less than two years or three years away, you would do well not to go with equity or equity-oriented hybrid funds, you would do well to choose debt mutual funds or fixed income mutual funds whereby chances of drastic movements or chances of capital loss are very, very less. Debt mutual funds also have NAV fluctuations due to various debt market dynamics.Take us through the different types of debt funds that are available for investors to invest their money based on their needs and the time duration they want to put their money for.
Amol Joshi: I keep going back to equity mutual funds simply because equity mutual funds are well known and better understood by investors; the way in equity mutual funds, you have largecap, midcap, smallcap or flexi-cap, multicaps. All I am trying to say is just the way you have wide range and variety in equity mutual funds, same is the case with debt mutual funds.
In debt mutual funds, you have a product called overnight fund and the name itself gives away what it does. In overnight funds, if you have one-day excess money, in the sense of money that you would need only tomorrow and you want to earn something better than your bank account, savings account or current account rate, you should go ahead and invest it overnight. This fund is suitable for investments of one day, two days, one week or 10 days. That is the extremely lower end of the spectrum. You then have liquid funds.
Liquid funds are suitable typically for a few weeks or a fortnight or a month or so. Then there is the completely other end of the spectrum where we have the 20, 25, 30-year maturity debt funds as well. Now, any advisor or planner would suggest that you should invest in line with your financial goals. Within financial goals also there are long-term and short-term goals. Now, let us take an example that you have some kind of lump sum money which you want to kind of allocate for your tuition fee of your child or children.
Now, this is the kind of money that you want to earn – something better than a saving account or short term FD, but you do not want that Rs 1 lakh becoming anything lower or lesser than that. Hence, you will not be able to go ahead with equities. What do you do? If the tuition fee payment for over next two years is one year and two years away, you will probably go with a low duration fund for your near-term requirement and a short-term or a medium-term fund for your two years away requirement.
So, there are multiple fund types. There is a dynamic bond fund where the fund manager chooses the maturity of the bond to be invested in. The dynamic bond, as the name suggests, is very dynamic, nimble footed. The fund manager has the flexibility to invest in a bond maturing in two to three years or maybe eight to ten years as well. Then, there are credit risk fund where the fund manager essentially has to go down the rating curve, choose maybe double A rated or single A rated papers and try to generate alpha compared to other higher rated instruments.
These are multiple types of debt or fixed income mutual funds that one can choose for investment needs.
Most people have financial plans or financial goals and have already begun investing towards it or they are somewhere along that journey. Now, if you want to incorporate a debt scheme into this, how do you make sure that that scheme that you are picking is perfectly in line with your end goal and mixes very well with the current plan that you already have?
Amol Joshi: You can invest into liquid funds and from liquid funds do the STP. So, the purpose here is not to generate yield or returns from your debt investments, the purpose is just to generate slightly more than your savings bank account and the ultimate goal is investing into equity so that is just one example.
The other example that we have already spoken of is low-duration and short-term or medium-term funds. How debt mutual funds fit perfectly into the plan is there are other ways as well. Now what are those ways is if you have a goal or maturity that is staggered over two years, three years, five years and seven years; typically you can say that suppose a higher education kind of four years or six years fees payment is something that you have in your mind and currently we are in 2024 and your goal first year of tuition fees payment is due for you for your child is into 2028, 29, 30 so on and so forth, so you also have something called as target maturity funds.
Now, again the name itself is a giveaway, target maturity fund simply means that it matures at a certain point in time to which you can align your target to, in the sense if you have fees payment due in 2028 you would choose a fund a target maturity fund that matures or gives money back to you, comes back to you in year 2028, so that first fund will have a four-year kind of maturity, for second year tuition fees you will invest into a five-year target maturity kind of a fund, six years, seven years, so on and so forth.
This fits very well because you do not have to remember to redeem your investments, similarly the fund automatically matures and comes to your bank account and last but not the least, these are as we have mentioned, as we are talking about debt or fixed income mutual funds, these are non-equity oriented funds, so you will typically make coupon, the kind of coupon that your fund generates minus the expense ratio of the funds or call it net YTM that is the kind of return that you can expect and obviously all the target maturity funds here invest into highest rated triple A rated securities so from that barometer as well the funds are very-very safe, you will get a coupon for next four years, suppose it is 7% so you will get a 7% compounded kind of returns over four years, five years, so on and so forth and that is how a debt fund, something like a target maturity fund fits perfectly into your existing financial plan.
The Fed keeping its rate steady, the RBI is expected to closely follow the Fed and in an environment where the market tends to react rather sharply to any interest rate hike, cut, or any anticipation and if that is not what turns out to be in the market, the stock market reacts in a rather adverse way. Amid a situation like this, would you recommend picking a debt instrument over an equity instrument to anchor yourself in the market?
Amol Joshi: Again, I think we are touching upon the very important role that debt mutual fund play. See, over a long term equity has proven to be inflation beating asset class, so that is understood by everybody and people do go to equity to generate kind of higher returns. But there is a part of your portfolio that you want to shield and that you do not want to be exposed to any market volatility. You rightly mentioned debt mutual funds also come and exactly fulfill the very same requirement. These funds do not invest into any equity asset class and equity shares. So, these are primarily shielded from equity markets to begin with, to start with.
Having said that, if you choose the highest kind of rating profile to invest into debt mutual funds, then you are also shielded from company defaults. There have been cases that a single A rated or double A rated bonds have either postponed their coupon payments principle as well as coupon interest rate payments, in some cases there have been defaults as well, but generally the triple A rated instruments or quasi-government, government sort of bonds have given an excellent avenue for investors to invest their moneys to any asset class other than equities. Not just that you also touched upon a point of interest rate cycle.
As we all know last one-and-a-half, two or more than that globally the central bankers have been hiking interest rates and the way it has reflected in your bank FDs, bank FDs during COVID you got as less as 4.75% kind of return and similar bank FDs are today at north of 7%. Similarly, you also can today invest into highly rated bonds at anywhere close to 7.5% coupon rate, so that fulfils certainly one aspect where you want to shield your portfolio away from equity market volatility and not just that it also does an important function of asset allocation.
Just imagine for a moment when market really falls, you are somebody who wishes you had money to invest if the market has fallen by 20%, 30%, 40%; if you are completely invested into equity markets, you would not be having a free cash flow to participate into equity, that is where asset allocation comes into the picture. Your debt mutual funds are the funds that you can switch or redeem and invest into your desired equity portfolio. So, these are several kinds of functions that a debt mutual fund or fixed income mutual fund fulfills in an investor’s portfolio.
Now when we talk about a debt mutual fund, we use the term fixed income interchangeably and that also gives an impression in investors’ mind that the income over here is to a very large extent guaranteed. While the risk is nominally lower than when you put your money into equity mutual funds, a fixed income is not guaranteed. Could you elaborate on this myth that if we put anything into debt mutual funds, the income is going to be a fixed amount?
Amol Joshi: That is a very important point. Fixed income, the name itself in this case at least is slightly different than the reality. In one of the previous answers I also touched upon the fact that debt mutual funds NAVs are also subject to debt market volatilities. Now, what kind of volatility? Equity volatility people understand; that market is up or down. But what happens in debt?
In debt there are various factors; there’s the factor of credit risk. Those are the issuers who are at the lower rung, single A rated or double A rated or A minus rated. These are not the highest rated, most sound corporates that are out there, but that does not mean that they should not be able to mobilise funds via bonds. That is the reason you have credit risk funds or companies that are lower rated. But debt mutual fund NAVs are susceptible to volatility based on the interest rate scenario also.
This could be slightly complicated to understand but if the interest rates are going up, then bond prices fall. So, it is said that bond prices have an inverse relationship with yield. If the yield or interest rates go up, bond price falls because when the bond ultimately matures and if the issuer fulfils the obligation of returning you the principal and the coupon, you will make the kind of money that we discussed earlier yield to maturity sort of the return you will make.
But for the intermediate period when market rates are rising, the temporary mark to market impact can be there into debt mutual funds and in some cases, it will reduce your return from let us say 7% tentative to something a couple of percentage points lower. There have been cases in the past where interest rates drastically moved overnight. At least for a temporary period, debt mutual funds generated negative NAV as well. These are all market linked instruments and subject to market movements, market dynamics.
Last but not the least, and that is the very same reason why the mutual fund industry after every kind of advertisement or at every brochure, you will see that past returns are not predictable and mutual funds cannot be projected into the future and also mutual funds are not guaranteed instruments. If you remember this and have moderate expectations from this asset class I think that does a lot of good to your portfolio.