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Income generation with debt funds

Most of us understand how equity funds work. But how do debt funds generate returns?

First, it is important to dispel a common misconception with debts funds — that they cannot erode in value, just like fixed deposits. While debt funds are not as risky as equity funds, a part of your initial investment can erode, nonetheless. This is because these funds invest in various fixed income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments. The NAV on the debt fund can thus rise or fall along with the underlying bond prices.

And what impacts bond prices?

For one, interest rate movements in the economy can impact bond prices. If interest rates move up, bond prices fall and vice versa.

This is where the concept of ‘duration’ comes into play. As longer-duration bonds are more sensitive to interest rates, the fund manager of a debt fund will increase duration to cash in on the rally in bonds in a falling rate scenario.

Debt funds can also incur losses if they make wrong credit calls. Some debt funds capitalise on interest receipts. Thus they invest in bonds with lower credit ratings, betting on the credit risk to earn higher interest.

So, how can these funds suffer losses? If the company that has issued the bond defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off. This will impact the NAV of the debt fund.

Hence, debt funds can follow a strict ‘duration’ or ‘credit’ call or blend the two to come out with different strategies.

For conservative investors

For those looking for alternatives to bank savings and fixed deposits, liquid funds and ultra short-term debt funds fit the bill. While these funds are riskier than bank FDs, they carry the lowest risk amongst debt funds.

Liquid funds are the safest in the category, investing only in debt securities with a residual maturity of less than or equal to 91 days. With the maturity period this short, both interest rate risk and credit risk (default risk) are minimal. Liquid funds, on an average, have delivered 7-9 per cent returns annually over the last five years.

Compared to liquid funds, ultra short-term debt funds carry slightly higher risk, given that these funds invest in debt securities with residual maturity up to one year. The returns, though, can be higher. Over the past five years, returns from this category have averaged 7.5-9.5 per cent.

For investors looking at debt funds for a period of less than three years, their returns will be taxed at the income tax slab rates. Interest on savings accounts is exempt up to Rs. 10,000 under Section 80TTA of the Income Tax Act.

But even assuming 7 per cent return on liquid funds, post-tax returns work out higher than the 4 per cent that most banks offer.

Also, for large sums of surplus, liquid or ultra-short term funds still offer better returns.

While bank FDs for less than a year may offer returns comparable to those from liquid or ultra-short debt funds, should you need the money before maturity, you will be charged a penalty. Liquid funds allow you to exit investments without such penalties.

For moderate risk-takers

For investors with a slightly higher risk appetite and longer time horizon of, say, 2-3 years, debt funds, which generate returns both from accruals and duration calls (only moderately), may be considered. Short-term income funds and Banking and PSU Debt Funds fall under this category.

Short-term income funds invest in debt securities that mature up to 3-4 years. Their portfolios usually have a small allocation to long-term gilts and higher allocation to AAA-rated, medium-tenure, corporate bonds. Banking and PSU Debt Funds offer stable returns and minimise risk by investing in good-quality debt instruments, mainly issued by banks and public sector undertakings.

For high-risk takers

Investors willing to bet aggressively on either credit or interest rate movements can consider credit opportunities funds, regular income funds, dynamic income funds and long-term gilt funds.

Credit opportunities funds invest a relatively higher portion in lower-rated bonds.

Hence they carry higher credit risk, while duration is maintained at 2-4 years, minimising rate risk. Regular income funds carry higher rate risk but lower credit risk. Dynamic bond funds essentially ride on rate movements and alter the duration of the fund portfolio depending on the expectation of rate movements.

Gilt funds carry negligible credit risk. But as they carry a relatively higher duration of 7-10 years, they are more prone to rate risk. They can generate returns of 16-18 per cent in favourable markets but can also hurt when rates surge.

Hybrid/balanced funds

Hybrid or Balanced funds allocate assets both to equity and debt. While the debt portion performs the task of protecting the downside, the equity portion boosts returns. Risks vary depending on the extent of allocation to debt or equity.

For aggressive investors

Equity-oriented balanced funds invest more than 65 per cent in equity and the rest in debt. The higher allocation to equity helps deliver superior returns while also offering the tax benefit available to the equity diversified category (no long-term capital gains tax on investments held over one year).

For conservative investors

Debt-oriented schemes allocate up to 40 per cent and Monthly Income Plans (MIP) 10-30 per cent of their corpus into equity, thus pegging the risk lower.

However, returns are also lower than thoseof equity-oriented balanced funds. Moreover, as they fall under debt funds, capital gains within three years is treated as short-term capital gains.

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