September 18 , 2013
Knowing what securities make up debt mutual funds and factors that determine their returns can make your debt fund investment experience more satisfactory. Read on about basics of debt mutual funds such as how money earns returns, taxation aspects, NAV etc in this beginners' guide.
Where do debt mutual funds invest?
The money you invest in a debt mutual fund goes to debt securities giving fixed income. Some examples of debt securities are bonds, debentures, FDs, treasury bills, commercial paper. Not all of these financial instruments are familiar because most of them are used by business entities. They are called debt securities for the reason that all these are some form of borrowing. Interest rate of the security is what the borrower pays the buyer, who is the lender, in principle.
Debt funds are of various types. One of the ways they are classified is based on maturity of underlying securities. Unlike equities, all debt securities have a specific maturity date when they are retired. Maturities of debt securities can be as short as a day to as long as 30 years! Some debt securities like bonds, commercial papers can be traded with interested parties on the secondary market whereas others like FD, treasury bills are not traded. Some of the popular fixed income instruments debt mutual funds invest in are below
CBLO- Collateralized Lending and Borrowing Obligation is issued and traded by banks, NBFCs, and other financial intermediaries. Maximum tenure is 1 year.
Commercial Paper- CPs are short term borrowings of less than 1 year duration by corporates and financial institutions. They are tradable.
Certificate of Deposit- CDs are like term deposit in banks. Their maturity is less than 1 year and they are issued by scheduled commercial banks. Individuals can buy them too.
Treasury Bills- T-bills are issued by RBI for the central government. They have three tenor- 91 days, 182 days and 364 days.
Cash Management Bills- CMBs are also issued by RBI for the government but are issued for maturities less than 91 days.
Bonds- These are long-term debt securities. Technically the term bond is used if it is issued by a government undertaking or development financial institution.
Debentures- They are long-term debt instruments issued by private sector companies. Debentures are of different kind; Non Convertible Debenture (NCD) is popular among them.
Gilts- These are long-term government securities whose maturity can be up to 30 years. RBI auctions them for the govt.
State Development Loan- SDLs are raised by state governments from the markets through auction.
Returns in debt funds- how they make money
We mentioned above that interest is one way how investors make money in bonds, debt instruments and debt mutual funds. Interest rate, or more appropriately coupon rate, depends on maturity of the instrument, credit rating of the issuing entity and prevailing interest rate in market. Returns of short term funds like liquid funds, ultra short term debt funds and short term debt funds more or less depends on the interest rate of the basket of debt instruments they invest in.
It is a fact that long term debt securities give higher returns than short term debt securities. This is because firstly, coupon rate of short term securities are lower than of long term securities since investors prefer to lend for shorter terms, just like if you lent to someone, you would want to have the money back at the earliest. Secondly, the price of longer-termed securities increases more than that of shorter-termed ones, in times of interest rate fall. This phenomenon of tradable debt securities called as price-rate relationship is briefed below. It is commonly associated with bonds since they are long-term and are tradable.
When interest rate expectation in the market is falling, price of existing bonds rises. This makes sense, since an existing bond would give higher interest than new bonds to be issued or being issued. Therefore, investors would be willing to pay higher price to buy such bonds. If it is a long term bond then so much interest buyers can expect to get. When market interest rates are falling debt funds with long term bonds would benefit.
Thus, another way debt investors can make money is by trading them. Of course, regular retail investors are not active here; however, fund managers trade underlying securities quite often, depending on their perception of opportunities and depending on the nature of underlying securities.
NAV of debt mutual funds
You might have noticed that though debt funds invest in debt securities whose interest is fixed, their NAVs keep changing. Hopefully by now you understand that besides interest rate, market price of underlying securities is a factor affecting return in debt funds.
Since these securities are traded daily in the secondary market, their prices vary so. Therefore, NAV of debt mutual fund also changes daily.
Taxation in debt mutual funds
Mutual fund investments can be in two options- growth, dividend. In dividend option, whatever returns the fund makes is paid out to unit holders. Dividends are presently not taxable however, distribution of dividends is. The fund has to pay this tax but they would not do this out of their pocket; they deduct that value from your returns before paying you. Currently dividend distribution tax in all debt mutual funds is 28.33%.
In growth option profits are not paid out, they become part of the fund's NAV. Whenever the unit holder redeems his investment he gets his share of the pie as on that day. Capital gains tax is to be paid if you choose growth option. If investment is redeemed after 1 year then long term capital gains tax of 10% is to be paid. With indexation benefit this is 20%. If debt fund investment is redeemed before completing one year then short term capital gains tax is payable. This is applicable at the tax slab you fall under.