Should you invest in a debt mutual fund?

Sridevi GaneshRegistered Investment AdvisorSavers generally think of fixed deposits as the only option to generate predictable return. In fact, in the fixed income space, there are many options available. Debt oriented mutual fund schemes, bonds, debentures, and tax free bonds are a few to think of. But these have remained out of sight of most retail savers. Lack of awareness is one reason and the perception that fixed deposits are the only safe option is another. Having said that, there are flip sides too. What is a debt oriented mutual fund scheme?A debt oriented mutual fund scheme invests in government and corporate bonds to generate regular income over a period of time. The objective of such schemes is to provide capital appreciation by way of accrual of interest income or coupon payment received from the bonds. Mutual funds generally provide diversification to counter concentration risks be it equity or debt. Here also, the fund manager chooses to invest in a portfolio of bonds. The fund manager and his team would ensure that the bonds thus chosen for investment are of good quality. This is usually determined by referring to their ratings issued by rating agencies like CRISIL, ICRA or CARE and independent analysis conducted by the credit analysts with the fund house. What is in it for you, as a saver?If you deploy money in a fixed deposit, you know what is the return you would get in the next one year and the bank gives you a maturity amount based on the interest offered. A bank lends to company and others to generate an interest income and a portion is retained as profits before disbursing to savers an interest component. Similarly a debt mutual fund scheme earns interest and distributes to investors of the scheme by retaining a portion called expense ratio. Well managed debt mutual fund schemes, in the past, has beaten fixed deposits by a margin of 0.5% to 1.5% without facing any default from their borrowers. Though this is not guaranteed in future, this is highly likely and as an investor you can benefit out of this. What should you look at in a debt scheme?Yield to maturity is one parameter that indicates the attractiveness of the underlying bonds in the scheme. Though this should not be confused with the return expected, it is presumed that yield to maturity minus the expense ratio is the number around which the scheme delivers. If the yield to maturity is 10% and the expense ratio is 1%, then a return of around 9% is a possibility. To put more simply, this acts as a reference point for future returns and not a forecast of return. What are the risks associated ?Credit risk, interest rate risk & ratings downgrade risk are the three that you cannot avoid while investing in such schemes. If a particular corporate does not pay back the capital then that will have an impact in the scheme. Similarly falling and rising interest rates would induce short term volatility and would affect the yields. The fund manager would be having backup safety mechanism in case of a default in payment on the stipulated time by the borrower. This acts as an additional measure to mitigate credit risk though it cannot totally eliminate credit risk. Interest rates are bound to change and the volatility associated with such changes are hard to eliminate in total. Ratings downgrade – the risk that the bonds held would be downgraded by rating agencies. This too will affect the yield of the portfolio of the scheme. Taxation – If the investment is redeemed in less than or equal to three years, the gains are treated as short term capital gains. If the investment is redeemed after three years, the gains are treated as long term capital gains. Conclusion – A debt mutual fund scheme is an attractive option for retail investors. The returns are likely to beat conventional deposits, though this is not guaranteed. Past performance supports this argument in a big way. Investors in the high tax bracket would also enjoy better tax adjusted returns if the investment is held for a period of more than three years. Bonds invested through such schemes are of good quality and risk mitigation processes are in place. Investors should definitely consult an investment adviser before going ahead as there are many variants available.