Debt Mutual Funds: Do You Like to Know the Basics of them?

Here, I am trying to explain in one article about these funds.

I have seen many investors not investing in debt mutual funds.

In addition, the main reason for it is they do not understand them well.

And they feel that the rate of return will be very low compared to equity.

As a result of these, investors stay away from debt funds.

Let’s explore further to understand better in this article.

Debt Mutual funds are needed for your overall portal diversification…

We always say that all the eggs should not be kept in one basket.

In order to prevent eggs from being damaged, we follow this process.

If some eggs in the basket get damaged, then there is a high chance of other eggs also getting damaged.

Here, the above quotation applies to our investment also.

And we should not invest all our money in one asset class.

Moreover, we need to invest our money at least in 3 to 4 asset classes.

Many investors feel that equity is powerful, so we will invest in equity only.

Some say debt or debt funds have low risk; my capital must be invested in debt funds only.

Here, in this article, we are discussing only debt funds.

After reading the above quote, you may have understood the importance of asset allocation. I.e., investing in different assets.

In addition, a debt portfolio is as important as equity, real estate, and gold for your portfolio construction.

However, how to build a suitable debt mutual funds portfolio is a tough task for many investors.

• • Your debt portfolio is a low-risk investment compared to your equity portfolio, and to protect you from the downside risk. Both equity and debt have a low correlation.
  • Low co-relation means both the assets behave differently in terms of returns and volatility.
  • In addition, equity has a high risk and high volatility. Now you need debt to lower the volatility in your overall portfolio.
  • But do remember, debt will give low returns compared to equity.
  • In addition, if you look at the yeild portion of bonds or debt funds, this keeps changing every day, and it will not be constant like bank fds, PPF, etc.
  • If you are afraid of change in yield on daily basis, then invest only debt products like PPF, bank fd, SSY, senior citizenship scheme, etc.
  • If we go to a hotel, we do not need all the breakfast items for us.
  • Similarly, all the debt mutual funds products we do not need. We may need one or two products only.

Advantages of debt mutual funds…

Earlier, I explained about some basics.

Now, its time to know about the advantages off these funds.

# Liquidity... These funds allow you to liquidate whenever you need money very easily, subject to exit loads and taxes.

# Diversification… You can invest in multiple bonds using funds. In addition, these funds will invest in single maturity or different maturities based on the fund objective. Hence, the risk of holding a single issuer will be reduced.

# Taxation… Tax on these funds from 1st, April, 2023 is the same as bank FDs. However, there is no TDS and no tax until you withdraw these funds; these two features are still better than bank FDs.

What is a bond?…

Before talking about the disadvantages of debt funds, you need to know the bond concept.

First understand the bank before understanding the bond.

For example, if a bank needs money to lend, then they ask deposits from people for different time periods with different interest rates.

Based on our needs, we select the FD and will invest.

If the bank offers 7% interest for a 7-year FD, then after 7 years the bank will return the principal plus interest to the depositor.

In addition, the bank may lend this money to the borrowers at a higher cost, say 7.5% at least, to recover the expense of lending.

Moreover, you may have seen that different banks offer different interest rates for the same time period.

And in the case of cooperative banks, they offer much higher interest rates.

As all banks balance sheets are not the same, they cannot get money from the public at the same interest rate.

For example, SBI is a nationalised bank and has strong financials and will get deposits at a lower interest rate.

As a result of it, SBI will give loans to the public at lower interest rates.

Similarly, a cooperative bank that has low financial strength will get deposits at a higher interest rate.

In addition, they offer high-interest loans to the public.

Moreover, some borrowers still ask Co-operative Bank for a loan when their credit rating is low, and SBI may not give a loan for them.

Here, SBI will receive deposits at a low interest rate and lend money at a low interest rate. (borrowers with high credit ratings).

In addition, higher credit-rated persons generally do not default, hence low risk.

As sbi gives low-risk loans, the money deposited has low risk.

However, please note that low risk means a low return on your money.

Similarly, cooperative banks borrow money at high interest rates. Here, the depositors are willing to take high risks with these banks.

Co-operative banks will lend money to the borrowers at higher interest rates (who have a lower credit rating).

In addition, lower-credit persons generally default more.

Hence, your money will be at higher risk.

In addition, the higher the risk, the higher will be the returns.

i.e., why these banks offer a higher interest rate to the depositors.

Now, let’s come back to the concept of bonds.

When a company needs money, they have two options. 1. Ask. loan from the banks 2. Issue bonds.

But taking loans from banks has a lot of restrictions and permissions.

Many companies use the bond route also to get money for them.

Bond means it is just like a bank fd.

In addition, if the bond is issued at Rs. 1,000,.

and this Rs. 1000 is called face value.

In addition, the company may say that this bond will give 7% interest for 10 years; this interest will be a coupon.

Finally, the bond will give back the principal after 10 years.

For now, forget about these technical words.

Moreover, government, companies, and public sector undertaking companies issue bonds.

However, some bonds will give principal plus interest at maturity.

And some bonds pay interest on a yearly basis.

So, it all depends on the company and type of maturity, etc.

Risks in Debt Mutual Funds…

Already we have discussed the basics about debt mutual funds, the advantages of debt funds, and the bond concept.

Let’s again talk about bank FD first.

A bank has taken deposits at 9% interest for a 5-year period.

Here, you cannot cancel the bank FD without penalty in the middle of the term.

In addition, bank fds are listed in the market like bonds.

Moreover, if you really need money, you have to break the bank to get money. You will lose some interest.

When it comes to bonds, it is different; they are very liquid in the secondary market.

Let’s discuss the interest rate risk in the bonds or debt mutual funds.

Interest rate risk in bonds or debt mutual funds…

Let’s assume X is holding a bond having a tenure of 10 years and offering 8% interest. face value is Rs. 100.

In addition, assume that Y is holding a bond having the same tenure and offering 10% interest. face value is Rs. 100.

Again, assume that there is a bank FD offering 9% interest for a 10-year period.

Here, investors will prefer to invest in the bond that Y is holding in the secondary market.

As it is offering more interest among the three options that we have assumed.

In addition, investors may try to buy a Y bond at a premium to the face value, assuming the face value is Rs. 100. and sold at premium, say at Rs. 110.

As it is offering more interest than band FD and X bond.

So, the bond price of Y will increase here.

Here, investors will buy like this because, at the end of maturity, they may get higher maturity.

Hence, higher rate of return than bank FD, i.e., may be 9.3%, which is higher than bank FD, and face value may be Rs.110.

Similarly, if the investor wants to buy X bond, then the investor will not be willing to buy X bond at 8% interest.

Because the bank’s interest rate is 9%.

Hence, X has to sell his bond at a discount to the face value. Let’s say at Rs. 88.

and rate of return may be 7.5%.

So, it is very clear in both cases that Reserve Bank FD is the benchmark.

and bond prices and their yield will fluctuate on a daily basis.

Moreover, it applies to all government, corporate, and PSU bonds.

So, if the RBI increases interest rates, bond prices will fall, and vice versa.

Now, you understand two concepts here. 1. Interest rate 2. YTM.

YTM means yield to maturity.

In addition, this YTM will change daily based on the interest rate of RBi.

YTM Risk in debt mutual funds or bonds…

Earlier, we understood interest rate risk in bonds.

Now, let’s understand YTM risk in bonds.

YTM means yield to maturity.

In addition, it is nothing but the rate of return that investor is going to get if hold till maturity.

But do remember, this YTM will fluctuate on a daily basis, and an investor may get a higher YTM or a lower YTM if he is about to sell the bond before maturity.

Let’s assume a bond is paying 8% interest yeary, the time period of the bond is 10 years, and the bond is trading at Rs. 105.

In addition, bonds face value is Rs. 100.

Here, the investor will pay Rs. 105 to buy this bond. But he will get Rs. 100 only at the maturity of the bond.

You can see in the above image that the YTM is 7.28% percentage only though the bond is paying 8% interest per annum.

In addition, this happened due to the decrease in the interest rates in the banks.

As a result of this, bond prices will increase and YTM will fall, i.e., for the new buyers of the same bond at present.

So, with an increase in interest, YTM will increase, and vice versa.

Moreover, this YTM calculation is little difficult, so use readily available online calculators to do the calculation.

In the above example the YTM for first investor is 8% which is equal to coupon rate 8%.

But for the second investor coupon is same and YTM became 7.28% becasue of change in interest rates in the banks.

Hence, for the investors YTM is important parameter to look while buying the bonds than the coupon i.e interest rate of the of the bond.

If you see first underline, the bond is paying coupon of 7.04% but the YTM is 6.7254%. i.e YTM is higher than the coupon.

That means that price of the bond.

You can see in the above image that the price of the bond decreased to Rs.94 from Rs.100 with increse in YTM.

Finally, the debt mutual funds will hold a bunch bonds right? The fund will caculate the yTM of all bonds proportionately to arrive at the funds YTM.

Important Things about YTm…

YTm is the rate of return that the investor will get on the maturity if it is held till maturity.

However, the YTm may be higherr or lower, if he decides before maturity, depending on the interest rates in the banks.

YTM will not into consideration the buying and selling costs.

and YTM will not consider taxation part.

In addition,  we should not think Lower YTm is bad  and higherr ytm is good.

Moreovere, we need to see the credit quality of the issuer.

Because the higher YTm can be due to lower quality or interest rate change.

Read the article-  Poor to rich the path to follow?…

Also read the article Time Value of Money – How it help in right decissions.?

and read about Best business idea with low income.

also read about types of loans in India.

and read about Bima Jyothi Plan of Lic.

Also read the article about Types of Debt Mutual funds in India.

And read about Liquid funds in mutual funds in this article.

Also read about Is fd a good investment?…

And read about Bank Fixed Insurance Scheme – All you need to know…

Also read about Asset allocation and its importance…