Debt Mf Guide

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Preface

Although the awareness about mutual funds is growing among people, the range of offerings is

still underutilised. For many, mutual fund is synonymous to investing passively in equities even

today. But the fact is mutual funds also offer investment avenues to invest in fixed income

instruments through debt mutual funds. Further, they may coalesce the features of equity and

debt into one product which is known as a hybrid or a balanced fund.

Each category of mutual funds is vital for your asset allocation. While many investors take

exposure to equity through mutual funds; they shy away from debt mutual funds. It is mainly

the lack of awareness that proves to be a barrier between investors and their choice towards

debt mutual funds. Bank fixed deposits are widely used as a fixed income generating instrument

and majority of people stay in the confines of these traditional investment products.

Investing in debt mutual funds is a different ball game altogether. It requires some basic

understanding of how they work and what are the factors they are affected by.

Through this guide, we have tried to capture our expertise and experience for your benefit. This

will enable you to understand the wise and systematic way of investing in debt funds.

We hope it will be an informative reading and wish you a VERY HAPPY INVESTING!!

Team PersonalFN
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Disclaimer

This Guide is for Private Circulation only and is not for sale. The Guide is only for information purposes and

Quantum Information Services Private Limited (PersonalFN) is not providing any professional/investment advice

through it. The Guide does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to

an offer to buy or sell financial products, units or securities. PersonalFN disclaims warranty of any kind, whether

express or implied, as to any matter/content contained in this guide, including without limitation the implied

warranties of merchantability and fitness for a particular purpose. PersonalFN and its subsidiaries / affiliates /

sponsors / trustee or their officers, employees, personnel, directors will not be responsible for any direct/indirect

loss or liability incurred by the user as a consequence of his or any other person on his behalf taking any investment

decisions based on the contents of this guide. Use of this guide is at the users own risk. The user must make his

own investment decisions based on his specific investment objective and financial position and using such

independent advisors as he believes necessary. PersonalFN does not warrant completeness or accuracy of any

information published in this guide. All intellectual property rights emerging from this guide are and shall remain

with PersonalFN. This guide is for your personal use and you shall not resell, copy, or redistribute this guide, or use

it for any commercial purpose.All names and situations depicted in the Guide are purely fictional and serve the

purpose of illustration only. Any resemblance between the illustrations and any persons living or dead is purely

coincidental.


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Index

Chapter 1: Introduction to Debt market in India 6

Debt Market and Debt Instruments

Debt Market Regulators in India

Chapter 2: Understanding Debt Investment 12

ABCD of Debt Investing

Chapter 3: Introduction to Debt Mutual Funds 17

Why Debt Mutual Funds?

Various categories in debt mutual funds

Interest rate cycles

Understanding and calculating Yield and Duration

Chapter 4: Debt Mutual Funds vis--vis Traditional Fixed Income Instruments 26

Chapter 5: Need for debt mutual funds in your portfolio 29

Advantages of debt mutual funds in your portfolio

Parameters for selecting debt mutual funds

Chapter 6: Tax implication on debt mutual fund investments 35

Chapter 7: Investing in debt mutual funds made easy 36


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Chapter I: Introduction to Debt market in India

Majority of you get fascinated by the equity

markets as they tend to be more exciting, more

dynamic and of course they provide stellar

returns over the long term (sometimes over the

short term too, which creates further

excitement). But have you ever given a thought

onto what drives your excitement towards the

equity markets. Yes, you are right; it is the quest for extra ordinary returns that attract you

towards the equity markets just as a magnet attracts iron towards it. Well, equity markets are

absolutely a right choice for earning higher returns over the long run, but do remember that

high returns do entail high risks too. It means you need to put your invested capital at a risk and

that too without any expectation of preserving your capital (i.e. your invested amount).

And so to reduce the risk or to preserve your capital, you need an asset class which performs

the function of preserving or protecting your capital from eroding or turning negative. It is not

something new we are talking about. Instead, this asset class is a traditional asset class which

existed even much before equity became popular and exciting as an asset class. Yes, you got it

right; it is Debt as an asset class which we are talking about.

You must now be enthused to know more about this asset class and how would it help you in

protecting your capital investment.

Debt, in simple terms, is an obligation or a commitment from the borrower to repay the moneyborrowed from the lender on or before the expiration of the pre specified date on which the

final payment falls due.

Let us now probe more into the functioning of this asset class to get a deeper insight.


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Just like the equity markets where stocks or shares of companies are bought and sold; debt

market is a place where debt securities are bought and sold. Indias debt market is one of the

largest debt markets in Asia, and serves as a useful source for banking channels to meet their

financial requirements.

The Indian debt market has grown massively over the years. Before 1990s the debt market in

India was characterised by administered interest rates i.e. the interest rates were closely

monitored and fixed by the Government. Also the high Statutory Liquidity Ratio (SLR)

requirements led to the existence of captive investors in banks in the absence of a liquid and

transparent secondary market. The coupon rates offered on government securities too, were

not market determined. Such was the crude and unsystematic form in which the Indian debt

market existed earlier. However, through various reforms in phases over the past 20 years, the

Indian debt market underwent a process of a structural overhaul wherein the captive debt

market was transited to a more dynamic debt through market-determined interest rates, which

in turn brought about transparency and liquidity into the debt markets.

The Indian debt market can be broadly classified into Money Market, Bank and Corporate

Deposits market, Government Securities (G-Secs) market and Corporate & PSU Bond Market.

Let us now understand each of these segments in brief:

Money market: Money market refers to the market where the requirement or arrangement of

funds is for a short-term. Short-term refers to a period of less than one year. As such money

market instruments have a maturity of less than one year. The most active part of the money

market is the market for inter-bank overnight (i.e. less than a day) call and term money

between banks and institutions and repo transactions (banks' borrowing window from the RBI).

Certificate of Deposits (CDs), Commercial Papers (CPs), Inter-Bank Participation Certificates,

Inter Bank Term Money, Treasury Bills, Bill Rediscounting, Call / Notice / Term Money are some

of the money market instruments through which short term requirement of funds are met by


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banks, institutions and the State and Central Government.

Bank and Corporate Deposits: Bank fixed deposits (FDs) are very common amongst the

investors as a traditional investment avenue for decades. The tenure of bank fixed deposits

range from 7 days to 10 years. Corporate deposits are nothing but fixed deposits where the

issuer is a company or an institution other than a bank. Over here the interest rates vary

depending upon the credit quality of the issuer. Independent rating agencies assess the credit

quality of the company and assign the rating indicative of the risk involved in the investment.

Thus, higher the credit rating lower is the interest rate offered and vice-a-versa. However,

sometimes companies raise money without securing a credit rating from independent rating

agencies. In such cases companies often pay higher interest to attract investors.

Government Securities Market: G-Secs or Government Securities are units / debt papers issued

by the Government with a face value of a fixed denomination. In India, G-secs are issued by

Government of India at face value of Rupees One Hundred in lieu of their borrowings from the

market. These can be referred to as certificates issued by Government of India through the RBI

acknowledging receipt of money in the form of debt, bearing a fixed coupon or interest rate (or

otherwise) with interests payable semi-annually or otherwise and principal as per schedule,

normally on due date of redemption.

Government Securities includes all Bonds, T-bills and instruments issued by the Central

Government and State Government. These securities are normally referred to, as gilt-edged as

repayments of principal as well as interest are totally secured by sovereign guarantee.

Corporate & PSU Bond Market: Corporate Bonds are issued by Public Sector Undertakings

(PSUs) and private corporations. These bonds are issued for a wide range of tenor normally; say

for a period of 1 year to 15 years or even more. As compared to Government Securities which

are free of default risk; corporate bonds may turn out to be risky.


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This riskiness depends on the issuing companys credit rating, the business into which the

company is in, the sector in which the company operates and the prevailing market conditions.

It is noteworthy that term bonds and debentures are different. And it would be the right time

to know the difference between the same.

Debentures function more or less like bonds. One can also term debentures as a variant of

bonds. Debentures are issued by a company which offers to pay interest in lieu of the money

borrowed for a pre-specified period. In essence, it represents a loan taken by the issuer who

pays an agreed rate of interest throughout the life of the instrument and repays the principal

normally, unless otherwise agreed, on maturity. Bonds on the other hand are more secured

than debenture. As a debenture holder, you provide unsecured loan (most of the times

debentures are unsecured in nature) to the company. Debentures carry a higher rate of interest

as the company does not offer any collateral to you for your money. For this reason bond

holders receive a lower rate of interest but are more secure in nature.

Some debentures also offer put and call window, where the issuer can call for repayment or the

debenture holder can put for redemption after a certain period but before the maturity date.

Debentures are further categorised based on their security and convertibility to equity shares.

i.e. the debenture holder has the privilege to convert his status from a lender to an owner in

the company.

Based on convertibility, you have the following options to choose from:

Non-Convertible Debentures (NCD): These instruments retain the debt character and

cannot be converted into equity shares.

Partly Convertible Debentures (PCD): A part of these instruments are converted into equity

shares in the future at notice of the issuer. The issuer decides the ratio for conversion,

which is normally decided at the time of offer.


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Fully convertible Debentures (FCD): These are fully convertible into equity shares at the

issuer's notice. The ratio of conversion is decided by the issuer. Upon conversion the

investors enjoy the same status as equity (i.e. ordinary) shareholders of the company.

Optionally Convertible Debentures (OCD): The investor has the option to either convert

these debentures into shares at a price decided by the issuer/agreed upon at the time of

the offer.

Based on the security offered by the debenture, they are also classified into the following types:

Secured Debentures: These instruments are secured by a charge on the fixed assets of the

issuer company. So if the issuer fails on repayment of the principal or interest amount, then

the assets of the issuer can be sold to repay the liability towards its lender. However the

secured nature of the debenture does not guarantee your principal, but it only gives you the

right at par with the other lenders of the company to have a claim on the assets of the

company.

Unsecured Debentures:These debentures unlike the ones mentioned above, arent secured

against the assets of the company. Thus if an issuer defaults on payment of the interest and

(or) the principal amount, then you, as a lender, do not have a claim against the assets of

the company, and are exposed to very high risk.

Now, that you are aware of the various types of debentures let us move ahead and understand

as to who regulates debt market in India

Like any other market which needs to be regulated for its smooth and efficient functioning, the

debt market in India is regulated by Reserve Bank of India (RBI) along with the Securities and

Exchange Board of India (SEBI).

RBI: The RBI has the Money market and the G-Secs market under its purview. Apart from its

regulatory role it also performs several other important functions such as managing the


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borrowing program of the Government of India, controlling inflation (by managing policy /

interest rates in the country), ensuring adequate credit at reasonable costs to various sectors of

the economy, managing the foreign exchange reserves of the country and ensuring a stable

currency environment. Moreover, the RBI controls the issuance of new banking licenses to

banks. RBI also controls the manner in which various scheduled banks raise money from

depositors. Further, it controls the deployment of money through its policy measures on Cash

Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), priority sector lending, export refinancing,

guidelines on investment assets etc.

SEBI: The SEBI acts as the regulator for the corporate debt market and the bond market

wherein the entities raise money from the public through public issue. The regulation

comprises of manner in which the money is raised and tries to ensure a fair play for the retail

investor. It forces the issuer to make the retail investor aware of the risks inherent in the

investment, through its disclosure norms. SEBI also regulates the Mutual Funds and the

instruments in which these mutual funds can invest. Investment from Foreign Institutional

Investors (FIIs) also falls under the SEBIs scanner.

Well, apart from this duo, there are several other regulators which are specific for different

classes of investors such as the Central Provident Fund Commissioner and the Ministry of

Labour to regulate the Provident Funds. Also, Religious and Charitable trusts are regulated by

the respective Government of the state in which these trusts are located.

Now that you are aware of the debt market in India, you must be having this question in mind

as to how one with a small amount can have exposure to this stable asset class which helps in

generating regular income too. Well, the answer is simple and you may know it too.


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Chapter II: Understanding Debt Investment

Yes its bank fixed deposit.

Bank fixed deposit is one of the most commonly used

investment avenues in India. Traditionally, as you know bank

fixed deposits have been your favourite avenue to invest your

funds to generate fixed income. But today there is a plethora

of investment options available in the fixed income category,

which makes it difficult for you to choose from among multiple

bank deposits, hundreds of corporate fixed deposits and

thousands of small saving schemes.

Here are some myths about fixed deposits.

Some common choices for you to invest in fixed income instruments

Bank Fixed Deposits

Corporate Fixed Deposits

Corporate Debentures

Government Bonds

1) Fixed deposits with banks are totally risk free.Fact: They are not. Your deposits upto `1 lakh only is covered underDeposit Insurance and Credit

Guarantee Corporation (DICGC). Remember all your deposits with the same bank are clubbed

together.

2) Deposit schemes offered by corporate biggies are extremely safeFact: Corporate fixed deposits are not always safe. Many corporates can be in a bad financial

position.

3) Fixed deposit schemes offering higher interest rates are attractive investments

Fact: More often than not, companies with poor financials and troubled businesses have to pay

higher interest rates to attract deposits at higher associated risk.


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With various fixed income instruments and various issuers present in the market today, the task

of selection has never been as complex than as at present. Like equities, debt instruments too

are vulnerable to various risks. One should not blindly invest in fixed deposits offering interest

rates higher than the bank deposits. It is important to understand the basics of debt

instruments before you invest in them.

A B C D of debt investing

A debenture / bond or any other debt instrument is an obligation where the borrower agrees to

pay interest to the creditor for availing loan and also agrees to repay the principal after

specified time i.e. at maturity. Did you find a bit difficult to comprehend this?

Lets analyse step by step

Debt instrument is an obligation You must assess the repayment

capacity of the borrower.

Borrower agrees to pay interest Ensure that you are adequately and

timely compensated.

Borrower will repay on maturity You should have the time horizon

matching the maturity of the loan.

As seen above there are mainly three factors which you should consider as important in

analysing debt / fixed income instruments.

Which means?

Which means?

Which means?


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1) Risk involvedAnalysing the risk of default; known as credit risk.

2) Pricing of the loan Interest rate offered

3) Your investment Time horizon Maturity of the fixed income instrument.

Moreover it is important to understand the interrelation among these three factors.

When you lend money to somebody; you renounce the immediate use of money and hence

should be fairly compensated for these scarifies. Besides, you are exposed to the risk that the

borrower will not repay your money in time. This is known as the risk of default or the credit

risk. These two factors determine how much the borrower should pay you over and above the

amount of loan which is, in general terms, known as interest.

Greater the sacrifice Higher should be the reward hence, interest rate is higher for the loan

having higher maturity.

Higher the risk of default Higher should be the reward that is to say that you must be paid

the premium for undertaking the risk of loss

Higher the credibility of the borrower - lower would be the premium and vice versa.

Thus now you may have recognised the interrelation among the most important factors that

determine your returns from the investment in a fixed income instruments. However, to gauge

whether the interest rate offered by a debt instrument is higher or lower in general perception,

it needs to be compared with base or benchmark rates.

Here, the Reserve Bank of India (RBI) comes to the rescue. The RBI monitors and regulates the

broader interest rate movement. There are several factors which RBI evaluates before taking

any policy action on the interest rates as interest rates are considered as a sensitive issue since

it affects the total money supply and the borrowing and lending cost in the country.

RBI raises rates (repo and reverse repo rates) when it believes that the economy is over-heated.

Meaning, there is excess money in the system due to which too many people are chasing too


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few goods and services, which in simple terms increases the prices of goods and services thus

leading to inflation. On the other hand when the RBI believes that the economy is cooling off

(Lesser demand and over supply of goods and services leading to a slow down) it reduces the

interest rates to stimulate the demand.

The central banks job is very complicated as it has to see to it that the level of inflation remains

stable along with an eye on the economic growth of the country as well. RBI therefore observes

macroeconomic trends before taking any policy action. Higher nominal interest rate, rate which

is agreed to be paid on the deposit, doesnt necessarily translate into higher return to the

investor. If the level of inflation in the economy is high, even higher interest rate will not

generate real returns. For example if the rate of inflation in the economy is 10% and a term

deposit with a nationalised banks yields 10% then despite the double digit interest rate; real

returns would be zero. On the other hand if the inflation is 7% and a term deposit with a

nationalised bank yields 8% then despite the lower interest rate, the investment would

generate real income.

RBI raises interestrates to cool off

over heatedeconomy

Economic activitystarts falling

Economic activityfalls below thedesirable level

RBI lowers theinterest rates andeconomic activitystarts picking up

Economy booms


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For your better understanding, the chart below would help you take a wise decision on a bond

or a fixed deposit scheme you wish to invest in. You may also refer to the ratings assigned by

the independent rating agencies (such as CRISIL, ICRA, CARE, BrickWorks etc.). Rating agencies

follow their own set of parameters to assess the attractiveness of the bond or a debenture.

How many times in the past have you thought about the above mentioned aspects prior to

investing in a fixed deposit, bond or a debenture? It is always advisable to take help of

professionals for managing your fixed income assets as they also are exposed to various risks.

Here, the debt mutual funds come to the rescue.

Usually, the borrower has to pay more toattract funds when the general interest rates

in the economy are higher

Borrower usually pays more interest on debtmaturing over a relatively longer period

Borrower pays even higher rates if he is stillnot able to attract enough funds

Borrower pays more interest for theunsecured loans against which he is not

offering any collaterals

Returns from FixedIncome/Debt instruments

Ensure positive inflation adjusted returns. Set your time horizon

Check financial health of the borrower (Refer rating)High risk, simply avoid


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Chapter III: Introduction to Debt Mutual Funds

After reading about debt investing, we are sure you mighthave questions cropping up in your mind,

How can I take exposure and benefit from this stable asset

class which helps in generating regular income too?

Which is the right debt instrument for me that can help

meet my objective?

Should I invest in just one debt instrument or spread my

investment across debt instruments?

Is there a way that can make debt investments easy for me?

Debt Mutual Funds is an answer to all your questions!

Debt Mutual Fund is a pool of investments holding predominantly fixed income assets. The

main aim of debt mutual funds is capital preservation and regular income. Debt mutual funds

are less risky than the equity oriented funds. However, even debt mutual funds have to be

selected carefully as they too are exposed to some risks; although the nature of risk might be

different for the debt mutual funds and the equity oriented mutual funds.

Well then lets find out why one should go for a debt mutual fund.

1) Professionally managed portfolio of fixed income: As seen above, even debt

investments are vulnerable to risk and hence should be managed carefully. Professional

fund managers understand the larger picture of economy well. They help you align and

realign your debt portfolio according to the changing macro environment and dynamic

interest rates. The fund managers can take a timely call, if they see any interest rate risk

on their holdings, which, otherwise, may be difficult for an individual investor.


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2) Better post tax returns: Debt mutual funds enjoy some favourable tax treatment which

in turn helps you increase your net returns. Learn more about the tax treatment in the

Chapter: Taxation on Debt Mutual Funds.

3) Exposure to various securities which are otherwise not available for retail investors :

Some securities, including Government securities, have a very high ticket size i.e. the

minimum investment requirement is very high and hence are usually out of the reach of

an individual retail investor. However, debt mutual funds can pass on the benefit to you

by investing in a multiple of such securities thus widening your choice of investment.

Mutual Funds.

More about Debt Mutual Funds.

Debt Mutual Funds is a category of mutual funds, where the primary objective is capital

preservation and income generation. Chasing returns is considered secondary.

As seen in the above chart, there are various types and categories of debt mutual funds. Your

time horizon as well as your liquidity preferance is of utmost importance while selecting the

Debt Funds

Ultra Shortterm Debt

MoneyMarket /

Liquid Funds

Liquid PlusFunds

Short TermDebt

Short TermGilt Funds

Short TermIncome /

Floating RateFunds

FixedMaturity

plans

Long TermDebt

Long term GiltFunds

Long TermIncome /

Floating RateFunds


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right debt mutual fund for you, as portfolio structure and maturity structures for these sub

categories differ from each other.

It is noteworhty that debt mutual funds derive their income mainly from two sources:

1. The interest (coupon) they get on their investments in bonds and various fixed income

instruments

2. Capital Gains generated by trading in i.e. buying and selling bonds and Non-Convertible

Debentures (NCDs) in the secondary market

And this is where various category of debt mutual funds invest..

Type of Fund Invests in

Liquid FundsMainly invest in very short term money marketinstruments with maturity upto 90 days. Also invest incall money

Liquid Plus or Ultra ShortTerm Debt Funds

Portfolio is comprised of a mix of certificate of deposits,commercial paper, call money and other money marketinstrument with slightly higher maturity than theinstruments held in liquid funds

Floating Rate FundsTypically invests in short-term instruments offeringflexible interest rates i.e. whose interest rate reflectsthe prevailing interest rate in the country

Short-term Income FundsHave exposure to short-term bonds, deposits andNCDs. May also invest in T-bills and Governmentsecurities with maturity of less than 3 years

Fixed Maturity Plans of 3months to 36 months

Haveexposure to bonds and NCDs having maturityprofile in line with the horizon of the Fixed MaturityPlan (FMP).

Dynamic Bond / Flexi-Debt Funds

Such funds invest in short term as well as in long-termbonds and NCDs. May also invest in Governmentsecurities with maturity of less than 5 years

Long-term Income FundsInvest in bonds and debentures with maturity of morethan 5 years. Can also invest in Government securitieswith maturity profile of 5 to 10 years.

Gilt Funds or G-sec Funds Invests only in securities issued by the Government.


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Its noteworthy that, while debt mutual funds comprises of funds having pure exposure to debt

instruments, there are some hybrid funds with a dominant exposure to debt instruments along

with a petite portion in equity instruments.

Hybrid funds, like other mutual funds, are a collective pool of multi asset class investments.

However, they bring to you the best of both worlds; debt / fixed income instruments and

equities. Hybrid funds in their mandate stipulate the limit on the maximum proportion they can

hold in debt and equities.

Debt oriented hybrid funds such as Monthly Income Plans (MIPs) (there is no assurance of

monthly income though) hold predominantly debt assets with a dash of equities.

Conservative investors who wish to earn returns better than those earned on the bank fixed

deposits can invest in such funds. However, one should possibly have a longer time horizon (say

1.5 years to 5 years) to reap rich benefits.

Whereas some Equity oriented hybrid funds classified as balanced funds hold majority of

investments in equities with a considerable exposure to debt. Conservative investors who want

to earn equity alike returns but want to take a lower risk can consider investment in such funds.

We usually consider nominal interest rate (coupon) important for investing in fixed income

instruments. However, one needs to be cautious while investing in debt mutual funds as the

movement in interest rates has a bearing on the returns generated by them.

Before investing in debt mutual funds, it is vital to understand factors like yield and duration

and how the change in interest rates impact them and the valuation of debt instruments.

Interest rates and bond prices share an inverse relationship. When interest rates in the

economy move upwards, prices of bonds issued at the rate lower than the new rate go down

and vice versa. For example: A fund manager bought a bond issued at its face value of`100

which pays interest at 9% p.a. for 5 years. Now, if the rate of interest for a fresh series of bonds

with the similar maturity and risk profile earns 9.25% due to a rise in the interest rate, then the


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bond which the fund manager holds will lose its value and now will trade at a price below its

face value i.e. below`100. This is known as interest rate risk.

(Figures have taken for illustration purpose only, and thus values are hypothetical)

The interest rate sensitivity on the bond price depends on the tenure of the bond. Higher the

tenure of the bond higher would be its sensitivity to the interest rate movement. There are

chances that the investors will sell the longer tenure bond, if they are getting higher interest on

another bond of similar maturity. Investors will not be willing to bear the interest rate risk for a

longer period.

On the other hand, securities with lower tenure will be less volatile as the interest rate

movement is more predictable in the short run and short term securities offer interest close to

the prevailing interest rate for short tenure. Even if some other securities of similar maturity

offer slightly higher yield, then the investors can satisfy themselves at a slightly lower yield andhence take interest rate risk for a shorter period.


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Let us understand the connection between interest rates, bond prices and bond yields:

Let us now understand some important concepts you must know before investing in a debt

mutual fund.

Yield

Yield literally means profitability of your investment. However, in finance it denotes the rate of

return on your bond investment. It takes into consideration the income accrued by the way of

interest only. Further, there are different ways of calculating yield on bonds.

Current Yield

As you know, bonds can be bought at par (at their face value), at premium (by paying more

than their face value) or at discount (by paying less than the face value). Even so, the coupon

rate (rate agreed to be paid throughout the life of the bond by the issuer) remains the same for

you, no matter whether you are buying the bond at par, at premium or at a discount, but a

noteworthy point is that the yield though will differ.

(Source: Investopedia.com)

For example, say a fund manager bought a bond with a face value of`100 at par with a coupon

rate of 10% p.a. current yield will be 10%. But the same would drop to 9.80% if he would have

Interest Bond Prices Bond Yields

Bond YieldsBond Prices

Similarly

Interest


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bought it at`102. Similarly, if he would have purchased a bond at a discount of`2 to the face

value i.e. at`98, then the current yield on the bond would have moved up to 10.20%.

Yield to Maturity (YTM)

YTM, to simply put is nothing but the anticipated rate measuring the time adjusted total returns

that one will make on a bond as an investor, if he holds the bond till maturity date. YTM takes

into account the current market price, the face value, the interest payment that will fall due on

the bond and years left in its maturity. This calculation of the returns is based on several

assumptions which are:

Coupon payments will be made on time, and will be reinvested at the same rate

The bond is held till its maturity

Calculation of YTM is a complex process and hence usually done with the help of advanced

tools and functions on a computer.


Example: A 5 year bond with an annual coupon rate of 10%, paying semi-annually and boughtat`95 (Face value 100) exactly at the completion of 1 year will have YTM of 11.94%. Similarly,

when the same bond is priced and bought at`105, at the completion of one year, the YTM will

be 8.68%.

Another conclusion that can be drawn from YTM

If YTM > Coupon Bond is trading at a discount

If YTM = Coupon Bond is trading at par

If YTM < Coupon Bond is trading at a premium

Yield Curve

Yield Curve is a graphical presentation of various interest rates applicable on bonds with

different maturities but of the same credit quality. Analysing the shape of the yield curve is very


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important for the fixed income market participants as it helps them forecast the future

movement of interest rates.

Duration

The literal meaning of duration is the length of the time. However, in finance, duration has a

specific connotation. It measures (in number of years) the time taken by all expected future

cash flows of the bond to repay the time adjusted true value of the bond.

Factors affecting the Duration

Number of years left in the maturity of the bond

Coupon Rate and yields

Credit Ratings

Duration of bonds bearing high coupons and lower maturities would be lower as higher

coupons would take lesser time to equate the time adjusted true value of the bond. Duration of

a bond is an useful measure as bonds with higher durations witness high price volatility than

bonds with lower durations.


n = number of cash flows

t = time to maturity

C = cash flow

i = required yield

M = maturity (par) value

P = bond price

For example: A bond bearing an annual coupon rate of 10% and the yield of 10% maturing after3 years would have a duration of 2.73 years. On the other hand, bond with an annual coupon

and the yield of 9% having tenure of 5 years would have duration of 4.24 years. However, credit

rating plays a crucial role in determining the duration; as bond with lower rating would usually

quote higher coupon thereby realising the true time adjusted value of a bond faster.
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A bond with higher duration is more sensitive to the interest rate movement. As maturity nears

even a longer term bond would become less vulnerable to the interest rate risk.

Modified duration

A varied form of duration, measures the effect of each percentage change in yield on the

duration. It measures the effect that each percentage change in interest rates will have on the price of

the bond.


We have already seen that the bond with a coupon and the yield of 9% having tenure of 5 years

would have duration of 4.24 years. Assuming the bond is trading at par and pays interest on an

annual basis, the YTM will be equal to the coupon rate of 9%. Now, for a percentage increase in

YTM; the duration of the bond will decline to 3.89 years. In simple terms, the bond price will

decrease by 3.89% with a one percentage increase in interest rate and vice-versa.

Average Maturity: The average maturity of the portfolio determines the time involved in

maturing of all the debt assets in the portfolio of the debt mutual fund. Higher the average

maturity of the portfolio greater would be the interest rate risk on the portfolio of the debt

mutual fund.

Until now we have touched upon the basic concepts of fixed income instrument and debt

mutual funds to make you well versed with the principles governing the fixed income asset

class.

In the next chapter we will dwell on some fine nuances between traditional fixed income

instruments and the debt mutual funds which will help you decide upon which instrument is

the right choice for your portfolio.


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IV: Debt Mutual Funds vis--vis Traditional Fixed Income

Instruments

After having read about basic principles of debt mutual funds

and the fixed income bearing instruments in detail; you may

now like to compare debt mutual funds vis--vis traditional

investment avenues before considering them for investment

purpose.

Lets understand behavioural difference between them under

changing economic environment.

Rising interest rate scenario

Long term income funds and long term gilt funds become unattractive in the rising

interest rate scenario as bond prices tend to fall

Short term income funds and short term gilt funds too become ineffective. But impact

on the bond prices will be less severe for the short term funds

However, financial system might face a short term liquidity crunch due to monetary

tightening measures. Under such circumstances, liquid and liquid plus funds perform

better than the long term and short term debt funds

Floating rate funds shield your portfolio from the risk of rising interest rates hence

become attractive

Bank deposits and corporate deposits become attractive as they are now forced to offer

higher interest rates to attract funds

Other traditional fixed income instruments such as post office MIS schemes, Kisan Vikas

Patra, RBI Bonds, National Saving Certificate etc. are usually unaffected with the interest

rate movement and become unattractive in rising interest rate scenario if term deposits


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with large nationalised banks offer higher interest rates. These schemes are government

backed and hence are considered safer than any other traditional fixed income instrument

such as term deposits with banks.

Falling interest rate scenario

When interest rates start falling from their peak levels; long term income funds and long

term gilt funds become attractive as fall in interest rate will bode well for the bond

prices

Short term income funds and short term gilt funds benefit too but not to the extent long

term income funds and long term gilt funds doFalling interest rates ease the liquidity pressure in the system and liquid and liquid plus

schemes start losing their shine

Floating rate funds too become less effective and start giving lower returns

Banks and corporates offer lower rates to raise funds which make their deposits

unattractive for the investors.

As mentioned earlier, being less sensitive to the interest rate fluctuation, other

traditional fixed income instruments such as RBI Bonds, National Saving Certificates,

Kisan Vikas Patra and Post Office MIS Schemes become attractive if their interest rate

looks better in comparison with the rates offered by the large nationalised banks. On

risk return trade off they become more attractive.

Lets now qulickly check the advantages and disavantages of both the categories of

investments.

Parameters Diversification Liquidity ofinvestment

CapitalProtection

FavourableTaxation

Debt Mutual Funds

Traditional Fixed

Income Instruments

Denotes advantage Denotes disadvantage


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In short you need to analyse your situation before investing in debt mutual funds

How?

Heres the answer.

Ask your self simple questions

1) How long I dont need funds that are lying in my bank account?

2) What is my income tax slab?

3) What is the interest rate sensitivity of the category of funds?

4) Do I need to take an expert opinion on the prevailing interest rate cycle or am I well

equipped to do the macro analysis on my own?

Type of Fund Time HorizonYour liquidityrequirement

Interest rateRisk

Liquid Funds less than 3 months Very High Very Low

Liquid Plus Funds 3 to 6 months High Low

Floating Rate Funds 6 to 12 months Medium Low

Short-term Income Funds 1 year and above Medium Medium

Fixed Maturity Plans of 3 months to 15 months Strictly hold till maturity Low Medium

Dynamic Bond / Flexi-Debt Funds 2 to 3 years Low Medium-High

Pure long-term Income Funds 3 to 5 years Low High

Gilt Funds 3 to 10 years Very Low Very High

Traditional fixed income instruments and debt mutual funds have an important role to play in

your asset allocation. Though main aim of both these instruments is to provide stability to your

portfolio along with regular income; their effectiveness may differ with changing economic

environment. Moreover, fundamental attributes of traditional fixed income investments, asseen, differ from those of debt mutual funds.


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V: Need for debt mutual funds in your portfolio

Now, that you are aware of the various types of funds

available in the debt mutual fund category, selecting the

right type of funds for your investment portfolio is very

crucial. Remember your assets (corpus meant for

investment) must be allocated in different asset classes and

that too in the right proportion. This calls for a right asset

allocation suiting your risk profile and investment time horizon.

Well, without going into the nitty-gritty of asset allocation, let us understand the need or

advantages of debt mutual funds in your portfolio:

Exposure to a different asset class: Usually, equity mutual funds provide you with

diversification across stocks, sectors and market capitalisations. Along with this, your

portfolio needs diversification across asset classes too. Hence, owning a certain portion of

your assets in debt mutual funds shields your capital from the volatility of the equity

markets and at the same time helps you generate regular income.

Preservation of capital: Debt mutual funds as compared to equity ones are less prone to

wild swings and volatility. Thus, if you had sufficient exposure in debt mutual funds during

the 2008-09 crises, your portfolio would have been shock proof to that extent and you

could have limited the loss on your portfolio.

Low ticket size investment: Debt mutual funds provide exposure to a diversified portfolio of

fixed income instruments like Bonds, NCDs, Government Securities (G-Secs), Deposits,

Corporate Debt instruments, Certificate of Deposits (CDs), Commercial Papers (CPs) etc. As

the minimum investment amount in fixed income instruments is higher, gaining from such

diversification or holding a portfolio of debt instruments is not possible for an individual.

One can take this benefit by investing as low as`5,000 in debt mutual funds.


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Generation of income: Debt mutual funds help you in generating regular income as they

are the most suitable way of taking exposure to income-generating instruments like

Government Securities (G-Secs), Bonds, NCDs, Certificate of Deposits (CDs), Commercial

Papers (CPs) etc. without requiring you to commit huge sums of money, or without

worrying about transaction costs, stamp duty or lack of liquidity. Income funds are ideal in

generating regular income for the investors.

An avenue to park your short term funds: Unlike equity mutual funds which are very

volatile in the short term, debt mutual funds provide you with the investment avenue to

park your funds for a short span of time. Liquid and Liquid plus funds are the ideal category

to park very short term funds, while short term income funds are ideal for parking short

term funds. As discussed in earlier chapter, you need to select the ideal debt mutual fund

category based on your investment time horizon.

To generate income in line with interest rates: Debt mutual funds help you generate

income in line with the prevailing interest rates. However, you need to select the right type

of fund matching your investment time horizon as well as the one which is suited the best in

the prevailing interest rate scenario. Floating rate funds are designed to generate income in

line with the prevailing interest rates.

Now, going back to understanding the asset allocation strategy (by now you are aware as to

why you should invest a part of your portfolio in debt mutual funds), your risk profile depends

on a number of factors such as your age, income, expenses and nearness to goal.

And so if you are a risk-chaser kind of an investor then you may go aggressive on your asset

allocation exercise by tilting your portfolio more towards the equity asset class and less towardsdebt as an asset class. Contrastingly, if you are a risk-averse kind of an investor then it would

be sensible for you to allocate more of your assets towards debt asset class and less towards

equity as an asset class. Well, you may also be one of those who like to take risk in moderation

and thus you need to allocate your assets accordingly.


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Risk-Chaser Risk-Averse Moderate Risk

(For illustration purpose only and should not be construed as a model asset allocation)

(Source: PersonalFN Research)

Thus, debt mutual funds form an inseparable part of your portfolio.

It would now be interesting for you to know what parameters you should consider while

selecting debt mutual funds as an inseparable part of your portfolio.

A) Quantitative parameters:

Average Maturity: Depending on your time horizon you need to select the debt mutual

fund scheme which matches with your investment time horizon. The average maturity of

the debt mutual fund scheme should be lower, so that it is less vulnerable to interest ratemovements. It should ideally be in line with the suitable time horizon meant for the

particular category in which the debt mutual fund scheme is into consideration. For

instance, a liquid fund which is generally considered for an investment time horizon of

less than 3 months must have its average maturity below 90 days.

Track record of the fund house and the scheme: This is an important criterion as it is

wiser to keep your hard earned money in the hands of a well-established fund house with

good performance track record rather than in the hands of a fund house which is

relatively naive in the mutual fund industry. Also, depending upon the type of the debt

mutual fund scheme, it is imperative that the scheme must develop a minimum track

record to analyse its performance.


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Category Years of Existence

Liquid Funds Minimum 1-year

Liquid Plus / Ultra Short Term Minimum 1-year

S.T. Floating Rate funds Minimum 2-year

L.T. Floating Rate funds Minimum 3-years

Short Term Income Funds Minimum 2-year

Long Term Income Funds Minimum 3-years

Short Term G-Sec Funds Minimum 2-year

Long Term G-Sec Funds Minimum 3-years

Performance: The performance parameter should not be considered only on the basis of

the returns generated by the debt mutual fund over a period of time say, 6 months, 1

year, 2 years, 3 years etc. A more holistic approach should be adopted by considering the

risk adjusted returns (as denoted by the Sharpe Ratio, higher the better) and performance

across interest rate cycles.

Under the performance criteria, you must make a note of the following:

1. Comparison: A funds performance in isolation does not indicate anything. Hence, it

becomes crucial to compare the fund with its benchmark index and its peers, to draw

any meaningful conclusions. Again, you need to be careful while selecting the peers

for comparison. For instance, it doesnt make sense comparing the performance of a

liquid fund to that of a long-term income fund. Both the schemes considered for

comparison should be from the same category. It should not happen that you

compare apples with oranges.


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2. Returns:Returns is an obvious and one of the important parameters that one must

look at while evaluating a debt mutual fund. But remember, it is not the only

parameter. Many of you simply invest in a fund because it has given higher returns.

Such an approach for making investments is not beneficial at all. In addition to the

returns, you must also look at the risk parameters, which explain how much risk the

fund has taken to clock higher returns.

3. Risk: The volatility in returns is normally measured by Standard Deviation (SD). SD

signifies the degree of risk the fund has exposed its investors to. From an investors

perspective, evaluating a fund on risk parameters is important because it will help you

to check whether the funds risk profile is in line with your own risk profile or not. For

example, if two funds have delivered similar returns, then it would be prudent for you

to invest in the fund which has taken less risk i.e. the fund that has a lower SD.

4. Risk-adjusted return: This is normally measured by Sharpe Ratio (SR). It signifies the

excess returns generated by the fund over and above the returns generated by a risk

free asset for each unit of risk undertaken. Higher the SR , better is the funds risk

adjusted performance. Thus, it is important to choose a fund which has deliveredhigher risk-adjusted returns. In fact, this ratio tells us whether the high returns of a

fund are attributed to good investment decisions, or to higher risk.

Expense ratio: Higher the expense ratio lower will be your net (take home) returns. So

you need to be smart enough to be aware of the expense ratio charged to you by the debt

mutual fund scheme.

B) Qualitative parameters:Portfolio Characteristics: The credit quality of the debt mutual fund is determined by the

quality of debt securities that the fund invests in. For instance, a debt mutual fund


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investing in only AAA / P1+ rated and sovereign securities will be better in quality and also

will be in a better position to generate stable and credit risk free returns for its investors.

Investment systems and processes: A debt mutual fund following a set of prudent

investment systems and processes, has greater chances to generate stable returns; as the

fund managers need to follow the investment philosophy set by the Asset Management

Company. Thus, the debt mutual fund scheme in this case will not be at the sole mercy of

the fund manager. It will also take care of the performance risk associated with the

sudden change of fund manager.


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VI: Tax implication on debt mutual fund investments

Whenever you select any form of investment, make

sure you are well versed with the taxation part of it too.

Knowing the tax implication will help you understand

the net returns (after adjusting for tax) you will enjoy on

your investments.

To make things easier for you to understand, the below

table portrays different ways in which debt mutual funds are taxed:

Knowing this help you make smart decisions

Dividend Distribution Tax Liquid /

Money Market Schemes

Dividend Distribution Tax Liquid Plus /

Ultra Short Term / Income / Gilt Schemes

Resident

Individual / HUF

27.04%

(25% + 5% surcharge +

3% education cess)

13.52%

(12.50% + 5% surcharge +

3% education cess)

Partnership Firms

/ AOP / BOI

32.45%


3% education cess)

32.45%


3% education cess)

Domestic

Companies

32.45%


3% education cess)

32.45%


3% education cess)

NRIs

27.04%


3% education cess)

13.52%

(12.50% + 5% surcharge +

3% education cess)

Thus, coming to an end to this guide, we are sure by now you must have been quite thorough

with debt mutual funds and are ready to make smart decisions and more importantly not fall

prey to malpractices of your agent / distributor / relationship manager. You will now be able to

make a well informed investment decision when it comes to debt mutual funds.


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VII: Investing in debt mutual funds made easy

By now you must have well understood debt mutual

funds as a category and why it is an integral part of

your portfolio. But selecting the right kind of debt

mutual funds from a plethora of over 425 open ended

debt and hybrid schemes (and growing) in the market

might turn out to be quite a cumbersome task. To your

surprise the number of debt and hybrid schemes turns

out to be over 1,950 if you consider the various plans and options attached to them.

So it is not an easy job to select the right debt mutual fund scheme! You more importantly need

time, effort and expertise to find out which scheme would suit your investment requirement.

But there is some respite for you investors. With PersonalFNs DebtSelect service you can sit

back and relax as it takes away this pain from you and delivers experienced, unbiased and

credible advice on debt mutual funds in India. However, you may ask what is this DebtSelect?

DebtSelect is a research based subscription service on debt mutual fund schemes. DebtSelect

provides value added information on various debt mutual funds which helps our subscribers to

make well informed investment decisions. An in-depth analysis is done on the debt mutual fund

scheme and a detailed unbiased report is generated providing our brief outlook on the debt

market, review and quality of the schemes portfolio and comparison vis--vis its category peers

and the growth prospects of the scheme.

Our DebtSelect Service will make your debt mutual fund investment easy and provide you with

the right guidance on debt mutual fund investing that you were looking out for.


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About PersonalFN

PersonalFN, is a service brand of Quantum Information Services Pvt Ltd (QIS), and is

focused on providing research solutions and financial planning.

About PersonalFN Research

Since 1999, we have been researching mutual funds, insurance, fixed income instruments

and providing customized financial planning and premium mutual fund research to

individual clients in India as well as to NRIs.

PersonalFN follows a fundamental research process and uses an array of qualitative and

quantitative parameters to arrive at its recommendations.

What are the services we offer?

PersonalFN offers the following services:

a) Comprehensive Financial Planning (CFP)b) Ongoing Personalised Service (OPS)c) Mutual Fund Portfolio Reviewd) Investment Transactionse) Premium Mutual Fund Research Services

o FundSelecto FundSelect Pluso DebtSelect

Your PersonalFN Consultant will recommend a plan for you based on your life goals and

current financials

The investment recommendations are selected from a comprehensive set prepared by thePersonalFN Research Team based on their research on a combination of qualitative and

quantitative parameters.

The consultant will also explain to you how you can obtain one of the PersonalFN

Services.


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Nariman Point, Mumbai 400021.

Tel: +91-22-6136 1200

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Documents

Debt Mf Guide