Debt-based investments can be understood as fixed deposits, but tradeable on an exchange for a price determined by market participants or parties involved in the transaction.
There are different types of debt instruments available in India that are defined based on category of borrower (Central & State Government, Banks & NBFCs and Corporates) and instrument tenure (money market and long-term fixed income).
Money market instruments can only have tenures of less than 1 year
Long-term fixed income instruments can have tenures of any maturity (less or more than 1 year, as required)
However, there are significant challenges for retail investors to gain direct exposure to debt-based investments in India.
Lack of Knowledge and Platforms - Retail investors are unaware of how and where to trade in debt instruments
Lack of Liquidity - Parties are not easily available to trade in debt instruments and these investments follow an OTC model, i.e. transactions are arranged by brokers
Regulatory Constraints - e.g. retail investors were previously not allowed to trade in money market instruments
High Ticket Size - e.g. majority of the long-term debt instruments have a minimum ticket size of Rs. 10L
Debt Mutual Funds provide a convenient vehicle for investors to invest in debt instruments and avoid these challenges.
A preliminary understanding of return and risk factors inherent to debt instruments below will help you identify the appropriate debt instrument, followed by list of debt funds available across various categories.
Expected Return from Debt-based Investments:
As mentioned above, debt-based investments function similar to a fixed deposit - the borrower offers an interest to the lender over the period of the instrument. This interest is also known as Coupon.
Since these instruments are traded over an exchange, each debt instrument in the portfolio has an associated capital gain/ loss (calculated between buying and selling or maturity price of the instrument) further added to / subtracted from investor return.
Yield is the net expected return from the debt instrument to the lender / buyer if it is held to expiry. This includes the coupon payments and capital gain/loss (if any)
Risks Associated with Debt-based Investments:
There are two major risks associated with debt-based investments: Credit risk and interest rate risk.
While credit risk defines the credit quality of the borrower (its ability to repay the debt taken from the lender), change in interest rates impact the perceived value of the debt instrument in the market, depending on its tenure.
However, interest rate risk is minimal if a debt investment is held to maturity. There it is recommended for an investor to match their investment time horizon to the average maturity of the debt mutual fund, so that any loss due to increase in interest rates is notional and recovers as it approaches maturity.
Impact of Interest Rate on Value of Debt Investments:
Interest Rate is the standard repo rate set by the country's central bank (RBI in India)
The rise in bond yields lead to a short-term decline in the value of the debt instrument. However, bond yields tend to move in a range over a 5-10 year period. These ranges continue to decline as the economy develops, hence increasing the value of the bonds in the long-term. As shown below, the bond yields are at present near the lower side of their current range and expected to rise as the world economy improves after the COVID-19 pandemic.
Change in Debt Instrument Value = (minus) Change in Interest Rate X Modified Duration of Debt Instrument
Summary:
Potential investors could follow certain guidelines during selection of appropriate debt mutual funds:
Match your investment time horizon to the average Macaulay duration of the debt mutual fund
Prefer lower duration debt instruments if bond yields are near the lows of their yield curve range; Medium to Long duration debt instruments near the highs of the range
Check credit ratings of the underlying debt instruments - A1+ in short-term instruments, AAA in long-term instruments and SOV (government) securities should account for a majority of the portfolio's investments.
Ensure the underlying portfolio is sufficiently diversified such that there is minimal concentration risk
Please scroll below for a description of all debt mutual fund categories and performance and/or characteristics comparison of mutual funds offered by various Mutual Fund houses within the respective categories.
