Primer. Nuts and bolts of debt funds

With banks slashing their fixed deposit rates, have you been scouting for investments that offer higher returns without too much additional risk? You can consider investing in some debt mutual funds.

You can choose from liquid funds, ultra short-term debt funds and short-term debt funds. They have outperformed bank fixed deposits across various time periods.

Over the past one year, the top 10 funds (open ended) within these three categories have returned around 8 per cent, 9-10 per cent and 10-12 per cent, respectively.

Liquid funds, safest of the three, invest only in debt securities with a residual maturity of less than or equal to 91 days. With the maturity period this short, both interest rate risk and credit risk (default risk) are minimal.

On the flip side, while returns from liquid funds may beat bank FD rates, they may lag behind those of ultra short-term and short-term debt funds.

Liquid funds invest in fixed maturity interest-paying instruments, such as commercial papers (CP), non-convertible debentures (NCD), certificates of deposit (CD) and treasury bills (TBs).

CPs and NCDs are issued by companies for raising funds, while CDs are issued by banks against the money deposited with them. TBs are used by the government for funding its short-term liquidity needs and are issued by the RBI to financial institutions.

“Most liquid funds invest in securities with maturity of 45-60 days,” says Murthy Nagarajan, Head, Fixed Income, Quantum Mutual Fund. Under SEBI regulations, non-traded securities (such as CPs and CDs) that have residual maturity of up to 60 days, do not have to be marked-to-market. There can, however, be exceptions to this rule.

“If there is a sharp movement in the price of a paper by 10 paise and above (which converts into 50-60 basis points in a day for 60-day papers), then the movement needs to be recognised in the valuation of these securities. This type of sharp movement may be due to sharp hike/cut in local policy rates or other global developments.

These short term securities will be revalued based on the average price/yields of papers of similar maturities and similar credit ratings traded in the debt market. The valuation matrix will be provide by CRISIL and ICRA ” explains Murthy Nagarajan. Exceptions apart, non-traded securities maturing in over 60 days’ time too have to be valued in a similar fashion. When it comes to listed securities (such as TBs and NCDs), mark-to-market valuation applies irrespective of the residual maturity.

That is, such securities have to be valued daily based on their latest market price. As the prices of the securities fluctuate, so does the NAV (net asset value) of the fund, which can even turn negative. On the other hand, if a fund holds non-traded securities maturing in less than or equal to 60 days, then these are valued as per their purchase price.

This makes the NAV (sum of the value of the securities held plus daily interest accrued on them) of a fund less volatile and likely to keep on rising with each passing day as the interest accruals go up.

Compared to liquid funds, ultra short-term debt funds carry slightly higher risk given that the maturity of the securities held by the latter is a tad longer. Ultra short-term debt funds invest in securities with residual maturity of 90-100 days. That apart, since these funds hold 35-40 per cent of their portfolio in securities maturing in over 60 days that follow mark-to-market valuation, the NAV is more volatile, making the investment riskier.

The returns though, can be higher, given that the fund invests in securities of a slightly longer tenure compared to those in case of a liquid fund.

Short-term debt funds, which have the highest average maturity of the three, are also the riskiest. These funds normally invest in securities (maturing in one to five years) such that average residual maturity of the portfolio comes to 2.5-3 years.

Given the fairly long maturity, both interest rate risk and credit risk are much higher compared to that in the other two funds.

This is because, longer the time period, more the chances of fluctuations in interest rates and of volatility in the market prices of the securities held. Also, since all the securities are marked-to-market, the NAV is susceptible to much higher volatility. The risk of default too is greater. But, of course, taking on greater risk also gives you the opportunity of earning better returns.

Besides, in a falling interest rate situation (as is currently the case) short-term debt funds can fetch you higher returns compared to liquid funds and ultra short-term debt funds.

This is because short-term debt funds can stay put in the higher-interest securities they have invested in for longer, unlike the other two funds which will re-invest the funds from the maturing securities in new lower-interest instruments.

For all the funds, the capital gain on units redeemed in less than 36 months (short term) will be taxed at your income tax slab rate. If the units are redeemed in 36 months or beyond (long term), the capital gain will be taxed at 20 per cent with indexation benefit. Indexation adjusts your capital gain for the impact of inflation and will bring down your tax liability in a rising inflation scenario.

If you have opted for the dividend option, then the dividend will be paid out to you which, in turn, will bring down your NAV. But, the dividend will be remitted to you after deduction of dividend distribution tax of 28.84 per cent paid by the fund house.

In case of fixed deposits, the entire interest amount will be taxed at your income tax slab rate.

So, for those in the 20 per cent and the 30 per cent income tax brackets and redeeming their mutual fund units in 36 months or beyond, capital gains (after indexation benefit) will be taxed at 20 per cent. In these cases, the post-tax returns from a debt fund could be better than those from a fixed deposit.

COMMENT NOW