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Decoding the basics of debt mutual fund investments

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Decoding the basics of debt mutual fund investments

As with everything we learn, let us start this narrative by understanding the basics of debt investing and the emotions associated with the same. Any investment in debt involves finding answers to 3 questions – who is the borrower, what is the tenure of loan, and what can be the possible earnings (interest/yield etc).

Understanding the borrower
Whether we give money to a friend or a company or invest in a debt fund, it is important to ascertain the creditworthiness of the borrower/underlying borrower. This is assessed by understanding or knowing the credit ratings or backing of a guarantor/otherwise. The higher the score, the bigger the comfort in our mind.

Understanding the loan tenure

Whenever we give or invest money, it is important to be clear on when we will get our monies back. In short, we need to be clear on the time period that a borrower needs to return the money. This is what we call a date of maturity.

Understanding expected income

When we lend money we like to know the rate of interest, how and in what frequency will it be repaid. While investing in a fund, any investor would like to know his expected return on investment in terms of current yields etc.

A debt investor is fundamentally conservative and is looking to preserve their capital. At the same time, he is also looking to get the best possible income from his investment without diluting the primary emotions of caution and security. If any fund or a vehicle provides answers to the above basic questions while keeping in mind the fundamental emotions attached with it, then it surely can be very useful.

A high quality target maturity fund like Bharat Bond or PSU+SDL Index Fund ticks all the boxes as mentioned above. Lets see how it works –

Who is the borrower / underlying borrowers – In both funds, the underlying borrowers are AAA PSUs or State Development Loans(SDL). SDLs are similar to GSECs where the borrower is not the Central Government but various State Governments. The program is managed by the RBI.

What is the tenure? All these funds come with a defined maturity and the funds are returned to investors on maturity. There are various maturity options available like April 2023, April 2025, April 2026, April 2030, and April 2031.

What is the expected income? Regulations do not allow for any assurance on returns but the current yield to maturity of the portfolio is a reasonable indication of the possible outcome. However, this is not a guarantee of expected returns.

What are the other benefits or uncertainties involved with investing in target maturity funds as mentioned above-

Taxation – The income on maturity or redemption will be treated as capital gains. If the investment is held for more than 3 years then you will get the benefits of indexation and lower taxes. Indexation is a process which notionally increases the cost of investing resulting in lower capital gains. Additionally, a lower tax rate of 20% is applicable after such indexation.

Liquidity– If there is a need to withdraw monies before the maturity of the fund, it can be easily addressed as the funds are open for redemptions on a daily basis. ETFs can be liquidated on the Exchange whereas FoF and Index funds can be redeemed directly with the AMC.

Transparency – The portfolio/underlying borrowers are disclosed completely on the website on a daily basis in case of ETFs and on a weekly basis in case of Index Funds.

Rule Based Selection – The portfolio is selected on the basis of an Index and as per regulations which clearly define the dos and donts to be followed.

Uncertainties – The underlying borrowers will pay periodic interest which will need to be further reinvested. The rate of reinvestment will impact returns of the fund. Inflows and outflows during the tenure of the fund may also impact fund returns. In case of any delay or default by the borrower, it will add to uncertainty. Bharat Bond & PSU+SDL largely address this problem by investing in AAA PSUs and SDLs only.

In short a high quality target maturity fund could be an appropriate way to solve the basic needs of a debt investor in a very simple manner.

(The author is the Head-Sales, Edelweiss AMC)

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