Features of a Debt Fund

• 26 February 2017 | 1860 Views | By Mint2Save

Debt fund is a fund that invests in bonds, or other debt securities. Debt Funds can be contrasted with stock funds and money funds. Debt Funds typically pay periodic dividends that include interest payments on the fund’s underlying securities plus periodic realized capital appreciation. Debt Funds typically pay higher dividends than CDs and money market accounts. Most Debt Funds pay out dividends more frequently than individual bonds.

Debt funds invest in medium-to-long term debt securities like government bonds and corporate bonds/debentures. Dividend from these funds are subject to 12.5% Dividend Distribution Tax. The fund is also liable to pay a surcharge and a cess of 10% and 3%, respectively, on the tax. The effective tax rate comes to 14.16%.

Why to invest: They are debt products and offer good liquidity also . If you want to invest some money for safe returns, and for short term goal, then debt funds are something you can look at. The main investment objectives of a debt fund will usually be preservation of capital and the generation of income. Performance against a benchmark is considered to be a secondary consideration to absolute return when investing in a debt fund.

 TYPES
Debt Funds can be classified by their primary underlying assets:
• Government: Government bonds are considered safest, since a government can always “print more money” to pay its debt. In the United States, these are United States Treasury securities or Treasury. Due to the safety, the yields are typically low.
• Agency: In the United States, these are bonds issued by government agencies such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corp. (Freddie Mac), and Federal National Mortgage Association (Fannie Mae).
• Municipal: Bonds issued by state and local governments and agencies are subject to certain tax preferences and are typically exempt from federal taxes. In some cases, these bonds are even exempt from state or local taxes.
• Corporate: Bonds are issued by corporations. All corporate bonds are guaranteed by the borrowing (issuing) company, and the risk depends on the company’s ability to pay the loan at maturity. Some Debt Funds specialize in high-yield securities (junk bonds), which are corporate bonds carrying a higher risk, due to the potential inability of the issuer to repay the bond. Debt Funds specializing in junk bonds – also known as “below investment-grade bonds” – pay higher dividends than other Debt Funds, with the dividend return correlating approximately with the risk. Debt Funds may also be classified by factors such as type of yield (high income) or term (short, medium, long) or some other specialty such as zero-coupon bonds, international bonds, multi-sector bonds or convertible bonds.
A debt mutual fund scheme invests in debt papers like government bonds, fixed deposits, approved private deposits and so on. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. The different types of debt funds are:
GILT FUNDS-They invest their corpus in securities issued by the government. These funds carry zero default risk,but are associated with interest rate risk. So, there could be a possibility that the debt funds lose some part of their net asset value (NAV) also. But these schemes are safer as they invest in papers backed by government.
INCOME FUNDS-They invest a major portion in various debt instruments such as bonds, corporate debentures and government securities.
MONTHLY INCOME PLANS (MIP) -They invest most of their corpus in debt instruments and minimum in equities. They get the benefits of both equity and debt market. These schemes are ranked slightly high on the risk-return matrix. These try to give you a monthly income in the form of dividends, which is of course not guaranteed. These funds are for investors, who have a big corpus initially, and would like to generate a monthly income for themselves with low to moderate risk.
SHORT TERM PLANS (STPS) -These funds are for those with an investment horizon of three to six months. These funds primarily invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of the corpus is also invested in corporate.
LIQUID FUNDS- Also known as money market schemes. They provide easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, inter-bank call money market, CPs and CDs and are meant for an investment horizon of one day to three months.
Credit rating
An important property of Debt Funds is the rating of the bonds they own. Funds may be rated from high to low credit quality. The quality of a fund is the average of the bonds owned by the fund. Funds that pay higher yields typically own lower quality bonds.
Like stocks, the price of high-yield bonds is subject to fashion. For example, in late 2008, many high-yield Debt Funds were priced at 70 cents on the dollar. In fact, there were few bond defaults and the price recovered. Due to the lower price, investors sold out of high-yield Debt Funds, having a desire for “safe” cash and bonds.
Bond duration
Funds invest in different maturities of bonds. This may be described by terms like “short”, “intermediate”, and “long”. This affects how the fund value changes to interest rates. Funds invested in long bonds will have more change. As a general rule, the yield for longer bonds is higher. Debt Funds usually have a target length, such as five to ten years. Thus, over time, they need to sell shorter bonds and buy long bonds to stay in range. A Debt Fund with such a target length will never “mature” like a specific bond. Some UITs own bonds with a specific maturity date and will terminate at that point.
Advantages over individual bonds
• Management: Fund managers provide dedicated management and save the individual investor from researching issuer creditworthiness, maturity, price, face value, coupon rate, yield, and countless other factors that affect bond investing.
• Diversification: Debt Funds invest in many individual bonds, so that even a relatively small investment is diversified—and when an underperforming bond is just one of many bonds in a fund, its negative impact on an investor’s overall portfolio is lessened.
• Automatic income reinvestment: In a fund, income from all bonds can be reinvested automatically and consistently added to the value of the fund.
• Liquidity: You can sell shares in a Debt Fund at any time without regard to bond maturities.
Disadvantages over individual bonds
• Fees: Debt Funds typically charge a fee, often as a percentage of the total investment amount. This fee is not applicable to individually held bonds.
• Variable Dividends: Debt Fund dividend payments may not be fixed as with the interest payments on an individual held bond, leading to potential fluctuation of the value of dividend payments.
• Variable NAV: The Net Asset Value (NAV) of a Debt Fund may change over time, unlike an individual bond in which the total issue price will be returned upon maturity (provided the bond issuer does not default).

Total Return
Price charts on Debt Funds typically do not reflect their performance due to the lack of yield consideration. To accurately evaluate a Debt Fund’s performance, both the share price and yield must be considered. The combination of these two indicators is known as the Total Return.