There are two major ways to raise funding for a business. One way is to raise money from an investor and give them a stake in your company (thereby profits). This is called equity fund raising. The second way is to take on a loan and fund your company operations and growth. This is called debt raising and the investor (from whom the loan is taken) is called debt investor. Debt investors get a pre-determined rate of return and does not take part in the ups and downs of company valuation. In recent times, companies have been able to innovate different products to raise fund but by nature they broadly come down these two categories.
Debt investing is investing in any product that give you a pre-determined rate of return on your investment with limited maturity. Your savings account, FDs, NCD, MLD, Bonds, (Also lending money to friends and family) they all fall into this category.
Mutual fund debt funds are professionally managed funds with underlying investment in various debt instruments. It serves for individuals who do not have the ability or the capacity to evaluate debt products. Debt funds also offer diversification benefits. Unlike equity, debt instruments have limited liquidity as most of the investors tend to hold the instruments till maturity and the average ticket size is quite high. Because of this, individuals have a highly concentrated debt portfolio. They end up concentrating in low yield products like FDs and government backed bonds. Debt funds with smaller ticket size will give you exposure to multiple underlying instruments and issuers.
How to view a fund
This is where majority of retail investors struggle. There are two key metrics to look when you view a debt fund. One is yield to maturity (YTM) and other is duration. Debt funds hold various instrument which have limited maturity and predetermined rate. A fund with 9% YTM and 2.5 years of duration means that the underlying instruments of the fund on average mature in 2.5 years and will yield 9% return if you hold for this tenure. There may be some instruments maturing earlier or later. Also some instrument having higher or lower yield. The YTM and duration makes simplistic readable number for your understanding.
Sources of risk and return
Debt funds are preliminary exposed two major types of risk – interest rate risk and credit risk
If your existing fund has YTM of 9% and RBI came with interest rate hike. There will be new instruments available in market similar to your investment offering higher yield. There will be some loss in the market value of your debt fund (underlying securities). However, as securities in your fund mature, they will be reinvested at renewed higher rate
Credit risk is the risk the issuer fails to make timely repayment. Credit risk is higher for low quality issues (BBB rated and below). Government backed bonds have low credit risk. As you move higher the risk ladder, the better yield is offered to compensate for increased risk. A downgrading of an issuer by credit rating companies can also be part of credit risk. If your issuer is downgraded from AAA rating to AA, chances are the prices of the bond will fall causing mark to market losses.
Taxation
Major advantage of investing in debt funds is the taxation benefit. A fund held for more than 3 years (LTCG is defined as 3 years in debt), the gains will be taxed at 20% with indexation benefit. If the inflation is 5% for 3 years, you end up paying approximately 5% tax on your capital gains. Short term capital gains are taxed s per your tax slab (<3 years). You end up saving lot on your taxes as compared to FDs especially when you are in high tax bracket.
Suitability
Debt Funds are ideal for investors looking for stable returns with limited volatility. They are an ideal alternative to FDs. Investors who have visible upcoming liabilities can invest in these funds as there are funds with various duration. Eg: Investor expecting an child's college expense in 3-4 years can invest in medium duration funds.
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