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Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Understanding the risks of debt mutual funds

Unlike bank deposits, debt MFs offer neither assured returns nor guarantee the principal amount, as they are subject to market risks

Parking our hard earned money in bank fixed deposits is the preferred option for many of us. We are more comfortable with it as we believe that our principal is not at risk and on maturity, we will get it back along with interest. While borrowers are happy when interest rates go down, the investors, especially those who depend on interest income as their primary source of income, become worried as they now earn lesser on their deposits placed with banks.

At such times, while a few investors consider taking higher risks to compensate for the lower yield, many continue with their fixed deposits. They either do not know about the alternatives or are just too risk-averse. It is important for these people to know that there are other avenues that can provide similar (to fixed deposits) if not higher returns without taking on significantly more risk.

Debt mutual fund (MF) schemes can be an alternative to bank deposits. However, there are some basic differences between fixed deposits and debt MFs, which investors need to be aware of.

 Unlike bank deposits, debt MFs offer neither assured returns nor guarantee the principal amount, as they are subject to market risks. However, in most cases the pre-tax returns compare attractively to the bank deposits.

 On account of the differences in taxation rules, investors in debt MFs can benefit from lower taxes on their investments, thereby boosting their post-tax, overall returns. If the investment period is less than 3 years, then the returns from debt MFs are treated as short-term capital gains and clubbed with other incomes of the investor (just like fixed deposits). However, if the investment period is more than 3 years, then the returns are treated as long-term capital gains and taxed at lower rates.

 Deposits are subject to tax deducted at source (TDS) norms. This reduces the returns to the deposit holder as the benefit of compounding gets reduced. However, TDS is not applicable to debt MFs.

There are various types of debt funds on offer, such as: liquid, ultra-short, short-term, medium-term, income, and gilt funds. An investor can choose the schemes depending on her investment horizon.

Debt funds do not invest in equity. They only invest in debt instruments issued by the government, banks, and corporate entities, thereby partly ameliorating concerns of risk-averse investors.

You may have read that the price of a bond is inversely proportional to the yield. In other words, if its yield declines, the price of that bond goes up, and vice versa. Lets, say, an investor (A) has invested 100 in a 9% coupon paying instrument. After, say, one year, the interest rates decline to 8%. Now another investor (B) wants to invest, such that she gets the same annual income (9) for the next four years as investor A. She has two options. She can do it by investing a higher amount, of 112.50, at the current coupon of 8% giving her 9 every year and a return of 112.5 at maturity. Alternately, she can buy an existing paper that pays 9 per annum till maturity; for which she may have to pay a higher price as no new instrument will give a coupon of 9% today. In case she decides to buy the instrument from investor A, then A gets 103.3 on his investment of 100 in addition to the interest of 9, thereby increasing the net returns (ignoring transaction charges) from 9% to 12.3% for this one year period. Similarly, if the interest rates went down by only 50 basis points (bps), the total return to A would have been 10.6% over the investment period. One basis point is one-hundredth of a percentage point. Conversely, if interest rates go up the existing investor could suffer. This principle is used by the fund managers of the debt funds to time their entry and exit based on interest rate views, with an objective to improve the total returns to investors. In addition to the movement in interest rates, it would be good if investors also look at the underlying investments made by the schemes: the details of which are available on the respective websites or on the sites of various aggregators.

While interest rate risk is inherent in any debt security, one must be also careful on the credit quality. Given the large number of debt MFs, it would help the investor also checks on the underlying investments of the scheme shortlisted by them or their investment advisers. All fund houses are mandatorily required to publish monthly fact sheets of their schemes giving details of underlying investments.

As investors, including those who invest only in fixed deposit, have some understanding of a credit rating scale, (with rating symbols such as AAA and AA), they could look at the factsheet to gauge the proportion of such instruments in the portfolio. Usually, schemes with higher average residual maturity are more volatile to interest rate movements and consequently they invest more in government securities and papers rated at AAA, as these papers offer better liquidity in the secondary markets in addition to having sound credit quality. Schemes with shorter average maturity levels are relatively less volatile to interest rate movements and hence at times do tend to pick up relatively higher mix of AA+ or AA papers to provide better returns. Thus, opting for debt MFs can be a good option for investors based on their interest rate views, investment horizon, and risk appetite, especially in a declining interest rate scenario.

Karthik Srinivasan is senior vice-president, co-head, financial sector ratings, ICRA Ltd.

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