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The spotlight on debt funds

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Santosh Kamath, managing director, Local Asset Management – Fixed Income, Franklin Templeton Investments, India, shares insight on fixed income investment for long-term gains

How can a retail investor choose a debt fund depending on the investment horizon?

It is important to ascertain one’s holding period or investment horizon and identify a fund with a matching maturity profile. Most of the debt funds tend to specify an investment horizon (which is in line with fund’s maturity profile) where the endeavour is to help investors attain optimal risk adjusted returns. While investors looking to park their short-term surplus could look at money market funds, ones with short to medium- term horizon can take into consideration short-term or medium-term funds. Similarly, investors with long-term horizon can look at gilt funds or income funds, which have exposure to higher maturity instruments.


Other than investment horizon what should investors keep in mind? Are the parameters for selecting debt funds same as equity? Can you elaborate on each of the parameters?

Given the different nature of asset classes, the factors for selecting a debt fund differ from those which are considered before choosing an equity fund. While investing in a debt fund, in addition to investment horizon, investors should also look at asset composition, maturity profile and credit quality.

Asset Composition: This throws light on the investment approach of the fund manager. Debt funds tend to invest in various debt instruments, namely money market instruments, corporate bonds, government securities, cash, among others. For example, large exposure to government securities (g-secs), which are long-term instruments, indicates a prospect for higher returns in a falling interest rate scenario (as interest rates and bond prices are inversely related).

Maturity Profile: It shows the maturity of all holdings of the fund’s portfolio. This aids in comprehending the interest rate risk based on the fund’s investments in different maturity bonds/g-secs/money market instruments.

Credit Quality: As per the scheme’s investment strategy, debt funds can invest in securities with different credit ratings. These ratings are an indication of the credit worthiness of the borrower. Higher rating implies higher creditworthiness of the borrower.

Do riskier investments give higher returns in debt funds, just like equity investments?

Interest rate sensitivity (duration) is an important factor which tends to increase the possibility of higher returns in debt funds. For instance, in a falling interest rate scenario, a fund with higher duration is likely to benefit due to rise in the prices of the underlying bonds. Conversely, if the portfolio yields move up due to volatility or rise in interest rates, investors holding long duration funds also end up making mark to market losses on their portfolio.

How should investors look at the relationship between interest rates and returns in debt funds? Besides, is there a difference  between the interest rates offered by bank FDs and debt fund returns to choose between the two?

Interest rates and bond prices are inversely related, that is if the interest rates goes up, bond prices fall and vice-versa. In a falling interest rate scenario, higher the duration (interest rate sensitivity), higher will be the gain in bond prices. On the other hand, in a rising interest rate scenario, a higher duration could impact bond prices adversely. Our internal guidelines refrain us from providing any comparative analysis with other products.

Should taxation be one of the reasons to invest in debt funds, as compared to FDs?

Debt funds offer the benefit of long-term capital gains with indexation if the investments are held for more than three-year period. Our internal guidelines refrain us from providing any comparative analysis with other products.

What are some risks associated with debt funds?

There are three important risks investors face.

  1. Interest Rate Risk: Change in the interest rates impact prices of underlying bonds as interest rates and bonds prices are inversely related.
  2. Credit Risk: Lower credit quality portfolios offer higher yields, but that in turn increases the credit risk.
  3. Liquidity Risk: Liquidity is at ease with which portfolio securities can be sold. Lack of demand for a security could lead to liquidity risk.