Abstract
Debt schemes are mutual fund investments focused on
fixed-income securities, offering investors a mix of income generation and
capital preservation. This article introduces debt schemes, explains their
typical underlying instruments, categorizes risks involved, defines key
terminologies, and outlines the main types of debt mutual funds as per
regulatory standards.
Introduction
Fixed Income investment market is much bigger (at least 3
times) than the equity market across all
economies, and we have big list of investment tools available to invest in fixed
income underlying.
In this article, we will explore Fixed Income investment only
from Mutual Fund Perspective (India Market). These fixed-income mutual fund schemes
(here onwards Debt Schemes) pool investor money to invest in various debt and
money market instruments. They serve as a lower-risk alternative to equity
mutual funds, aiming to provide steady returns and preserve capital. A thorough
understanding of their components, risks, and classifications helps investors and
managers to align these schemes with their financial goals.
What Are Debt Schemes?
Debt schemes are mutual funds that primarily invest in
fixed-income instruments such as bonds, treasury bills, and commercial papers.
These schemes offer regular income through interest payments and potential
capital gains by trading these debt instruments. They are managed actively by
fund managers who select securities based on criteria like creditworthiness,
maturity, and yield.
Typical Underlying Instruments
Debt schemes invest in a variety of instruments including:
- Treasury
Bills (T-Bills): Short-term government securities with maturities
less than one year.
- Certificate
of Deposit (CD): Bank-issued negotiable time deposits with fixed
maturity.
- Commercial
Paper (CP): Unsecured short-term corporate debt.
- Repo/Treasury
Repos (TReps): Repurchase agreements used for short-term
borrowing. In Indian perspective, TREPS are low risk as they involve
government-issued securities and are of very short-term period(overnight to a few days or
weeks).
- Government
Securities (G-Secs): Bonds issued by the government with varying
maturities.
- Corporate
Bonds: Debt securities issued by companies to raise funds.
Risks Associated with Debt Schemes
We as Investor/Manager should be aware of the key risks
associated with debt schemes:
- Credit
Risk: The possibility that the issuer may default or downgrade,
affecting the value of bonds is risk of credit worthiness of issue.
- Interest
Rate Risk: As market interest rates rise, bond prices often fall,
negatively impacting the scheme's net asset value. This price sensitivity of
bond due to change in interest rate is called interest rate risk.
- Liquidity
Risk: The difficulty in quickly buying or selling debt securities
without significantly affecting their price. In simple term, this risk arises
when the fund cannot sell its holdings quickly without impacting the
price.
Key Terminologies
- Yield: The
return on investment expressed as an annual percentage, including current
yield and yield to maturity. Where Current Yield is calculated by
dividing the annual interest income by the current market price of the
security while Yield to Maturity (YTM) is the total return
anticipated if the investment is held until it matures, factoring in all
interest payments and the difference between purchase price and face
value.
- Macaulay
Duration: A weighted average time until cash flows are received.
- Modified
Duration: A measure of price sensitivity to interest rate
changes, showing how much the bond’s price will change for a 1% change in
interest rates.
- Sovereign
Bonds: Bonds issued by a national government, considered
low-risk.
- Credit
Ratings: Indicators of credit quality, where AAA is
the highest rating reflecting the lowest risk, followed by AA, A, and
below, which denote progressively higher risk.
Types of Debt Mutual Fund Schemes
According to regulatory classifications (from SEBI – web-link https://www.sebi.gov.in/legal/circulars/oct-2017/categorization-and-rationalization-of-mutual-fund-schemes_36199.html ),
debt schemes are categorized based on maturity and credit quality, some of the
popular categories mentioned below.
- Overnight
Funds: Invest in securities maturing in one day, offering high
liquidity and very low risk.
- Liquid
Funds: Invest in short-term money market instruments up to 91
days maturity, suitable for parking funds temporarily.
- Ultra-Short
Duration Funds: Invest in debt instruments with maturity between
3 to 6 months.
- Low
Duration Funds: Hold securities maturing within 6 to 12 months.
- Short
Duration Funds: Invest in securities with 1 to 3 years maturity.
- Medium
to Long Duration Funds: Carry securities maturing between 4 to 7
years.
- Long
Duration Funds: Securities with maturity exceeding 7 years,
sensitive to interest rate changes.
- Dynamic
Bond Funds: Actively manage portfolio duration based on interest
rate outlook.
- Credit
Risk Funds: Invest in lower-rated corporate bonds offering higher
potential returns with increased risk.
- Corporate
Bond Funds: Focus on high-rated corporate bonds with relatively
stable returns.
- Gilt
Funds: Invest primarily in government securities with minimal
credit risk but obviously attached interest risk.
Conclusion
Debt schemes offer a spectrum of investment opportunities
with different levels of risk and return, tailored to diverse investor needs.
Understanding the underlying instruments, associated risks, key terminologies,
and fund classifications equips investors to make informed choices aligned with
their financial objectives and risk tolerance.
