Over the last few weeks, I have been reading many articles on various aspects of debt fund investing. I have also received many queries on where investors should park their money to cushion against stock market uncertainty. To quote some of the more relevant questions:

• Are debt funds safe?
• So many companies are defaulting, will your fund default/ take a hit?
• Why should one choose a debt fund over an FD?
• Which fund should you invest in?

I thought I will write a basic article explaining the various types of debt funds and which ones you should chose in current market environment. But before I get there, here is a brief answer to the above questions:

[1] No, not all debt funds are safe. However, if chosen wisely, debt funds are a much better option compared to a Fixed Deposit. There are funds which invest in papers safer than fixed deposits, the problem however is that advisors often sell all debt funds as the same. The world of debt funds is like a forest which has an Oak tree and a flowery bush. Don’t confuse one for the other, choose based on season.

[2] Unfortunately, debt funds are being marketed without any checks or supervision. Also, there is no clear regulation on the type of instrument that each of these funds buy other than the classification of buying AA or AAA rated securities. When you buy a credit risk Debt Fund – sure, there could be a risk of default and losing a part of your principal, but you are also likely to earn a much higher rate of return over an FD too. When you buy a GILT (i.e. a government securities fund), you may not earn a very high rate of return but your investment will be extremely safe.

That said, unlike FDs, debt funds are listed instruments and will always move a few percentage points higher or lower depending on interest rate changes made by the RBI.

[3] Think of it this way: While FD Rates will change after RBI changes interest rates, debt fund values will go up or down all along. So when you invest in an FD your returns are locked and you know exactly what you will make. In debt fund however, after you invest, if RBI raises interest rates, debt fund value will immediately fall by 0-3% based on the quantum of rate increase, and vice versa. For this reason, there is always a possibility of making or losing that 2-3% any given day, but over time, it should all balance out.

[4] Over a longer period, you can make a much better return holding a debt fund over an FD. Further, returns generated in debt funds are tax efficient unlike an FD where you pay tax based on your income slab. I will not cover taxation of debt funds in this article, for tax implication of debt funds please refer to this.

UNDERSTANDING TYPES OF BONDS/ DEBT MUTUAL FUNDS

[1] The Gilt Fund – Gilt funds are debt funds that invest primarily in government securities. The gilt portfolio of these funds does not carry credit risk, only interest rate risk. These funds benefit the most in a falling interest rate environment. Currently, many GILT funds have generated a 1-year return of well over 15%.

[2] Credit Risk Fund – Credit risk funds are debt funds that lend at least 65% of their money to not-so-highly rated companies or less than AA rating. The credit risk funds are popular for generating higher returns by indulging into higher credit risks through investment in low rated papers. An extremely profitable fund type when economy is on the up, but this is the category where maximum defaults have happened over the past 2 years. Thanks to a very shaky economy we are in, things could deteriorate further. Currently, many debt funds are delivering negative returns. In fact, on average, the whole category of Credit Risk Debt Funds have delivered a negative 5% return in the past 1 year.

[3] Corporate Bond Fund (medium to long term) – Corporate bond funds are debt funds that lend at least 80% of their money to companies with the highest possible credit rating. That means these schemes would invest most of their corpus in corporate bonds that are rated AAA. This investment mandate makes them a relatively less risky than credit risk funds. 1 Year Average return of this category: 9.5%

[4] Overnight Fund – Overnight Fund are debt funds that invest in debt securities with overnight maturities. Overnight funds invest in reverse repo, CBLO, and other debt assets with a maturity of one day. Overnight funds earn through interest payments on their debt holdings. Naturally, this is an extremely safe category of funds since things usually don’t change overnight. You should expect to earn no more than 5% p.a. in this category. This category (and the next) should be used for short term parking of funds.

[5] Liquid Funds – Liquid funds invest predominantly in highly liquid money market instruments and debt securities very short tenure and hence provide high liquidity. The Fund invests in instruments that have residual maturities of up to 91 days to generate optimal returns while maintaining safety and high liquidity. Current 1-year category return average: 5.5%

[6] Bond Funds – Unlike a corporate Bond Fund (above), a bond fund is a mutual fund which includes a mix of different bonds and other debt instruments (including government Bonds). Bond Funds are further defined by time period to maturity, such as short-term, intermediate-term, and long-term.

• Ultra-short-Term Bond Funds – Low duration funds, with portfolio maturity of less than a year. Ideal for parking short-term surplus money; also offer slightly better returns than liquid funds.
• Short-Term Income Funds – Medium duration funds where portfolio maturity ranges from one year – three years. Investors with a horizon greater than one year can benefit from these funds in a rising interest rate scenario.
• Medium to Long Term Income Fund – Medium to long duration funds with portfolio maturity between three and 10 years. Suitable for investors with a longer investment horizon.

WHO SHOULD BUY DEBT FUNDS?

EVERYONE!

In general, debt funds are best suited for investors who have low risk appetite and prefer to invest in safe instruments like fixed deposits. Investment in debt funds is suitable for investors who want to earn satisfactory return on their capital by taking low to moderate levels of risk. That said, all Debt funds should not be compared to FDs. It all depends on your time horizon, your values and risk appetite.

When it comes to debt funds, I can not underestimate the importance of working with a fund manager who understands your needs and can manage things dynamically.

A WORD ON SOV VS AAA RATING IN DEBT FUNDS

While investing in bonds, investors must consider the issuer of the bonds. Bonds issued by corporations inherently carry more risk than bonds issued by the government. In a situation where a recession hits us, the issuer of the bond may go out of business and may default on the debt. The risk of default in government bonds is minimal, although it can still happen.

Role of Credit Rating and Its Importance – In simple terms, credit ratings are representations of the creditworthiness of corporate or government bonds. It provides the insights of the bond issuer’s financial strength and its repayment capacity.

Credit rating	Rating description
AAA	Highest safety
AA	High safety
A	Adequate safety
Below A*	Moderate/inadequate safety or high risk of default

*includes B, BB, BBB, C and D rated companies.

KEEP IN MIND, the Sovereign rating – SOV, MEANS country rating. A sovereign credit rating indicates the creditworthiness of a country and helps the investors to know the level of risk associated with investing in the debt of a particular country, including any political risk. As of 8^th May, 2020, S&P and Fitch have assigned BBB- sovereign rating to India with a negative outlook. This credit rating measures the ability of a country to pay back its debt.

Oftentimes, I have seen people (even analysts) putting SOV rating right on top of the table you see above. This is odd. There is no concept of sovereign rating in bonds. Keep in mind that sovereign ratings are for the country. In India, government bonds are often called or referred as sovereign rated, which is probably due to the fact that the government owns a large percentage shareholding in the issuing company.

Technically then, if the issuing company was not owned in majority (more than 50%) by the government, then its debt would get a rating based on the table above (anywhere between AAA to below A).

How can Sovereign rating of Country Impact the Company’s Rating?

I am sure that the most inquisitive ones will also think of this.

When a company raises funds internationally., then the country’s sovereign rating plays an important role. For example, Reliance Industries, which enjoys AAA status for domestic ratings, falls to BBB+ on the international scale. A sovereign rating downgrade will result in a downgrade of the company’s rating.

Which Debt Fund Should You Buy in the Current Market Environment?

Over the past few years, I have written and tweeted much about investing in debt funds, and the perils thereof. I have personally used these funds extensively to allocate client money based on overall economic environment. For most part, if I am not in equity, I choose the safest of debt funds based on liquidity in overall capital markets.

For the past 2 years, I have been investing in a mix of corporate bonds (short term) and GILTS. I hear a lot of people say that at such low rates of interest, GILTS are not such a good idea. Personally, I CHOSE THESE FUNDS WITH SAFETY OF PRINCIPAL AS MY TOP CRITERIA. Even though we have witnessed a rally in both, I CAN DISCLOSE: I will continue to stay focused in this space, moving more into GILT. In these times of uncertainty, they are the safest instrument with the highest return potential. Of course, things will have to be managed dynamically, you must be ready to move to equities or other funds based on many factors, most importantly – interest rates. That said, I expect the current low interest regime to continue for the foreseeable future.

WHICH DEBT FUND SHOULD YOU CHOOSE IN CURRENT MARKET?

As I said above, this is one area where you should be working with a good financial advisor. To be effective, you need to be dynamic in current market. That said, for some reason if you do not wish to work with a financial advisor, then choose a good open-ended debt fund. This gives liberty to the fund manager to move between various debt securities.

My favourite fund in this category – NIPPON INDIA NIVESH LAKSHYA FUND

The fund primarily invests in long term fixed income securities maturing in 7+ years, predominantly government securities at the current yields. As per fund disclosure, most of the securities would be bought and held till maturity. This presents a great opportunity to lock in long term interest in the safest asset class. Of course, if you wish to jump in and out of this scheme, your returns could be variable, but if you buy into this scheme to hold for 7+ years, you will make a far higher return than an FD.

Note: The fund is currently invested in government securities and is holding below instruments.

However, the scheme is open ended and can invest in any type of debt instruments including corporate bonds. This is actually good as it gives ability to the fund manager to move to other categories of debt investments based on expected/ actual interest rate scenario.

Other Aspects:

Expense: The fund has amongst the lowest expense ratio in its category (expense ratio of 0.21% for direct plan and 0.53% for regular plan).

Exit Load: 1% exit load will be charged on the amount of withdrawals done before 3 years from the date of investing (for units in excess of 10%).

Past Returns:

1-year Return: 16.25%

Return since Launch: 16.21% (date of launch: 6 July 2018)

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