Mutual funds have earned a lot of traction as an alternative to direct investment in the stock market. Mutual fund investment allows investors to gradually build wealth by investing through all market conditions into various asset classes. A broad classification of mutual funds includes – debt mutual funds, equity funds, and hybrid funds. Debt funds invest in different debt instruments and generate a return better than traditional fixed deposits while offering tax benefits. It appeals to a broad section of investors and essential for efficient portfolio diversification. In this article, we will discuss debt funds, returns, and more. So let’s begin by understanding what it is.
What are debt mutual funds?
Mutual fund investment allows investors to invest in various asset classes, including debt instruments. Debt mutual funds invest in all kinds of debt tools like treasury bills, commercial papers, certificates of deposits, government bonds, money market instruments, corporate bonds, and more to generate predictable returns of around 6.5 -12 percent before tax. They also offer tax advantages if held for more than three years. Usually, the fund manager distributes the fund into 20-22 different debt instruments to create a diversified portfolio and distribute risk to generate an attractive return for investors.
Return on debt funds depends on two factors – future interest rate and the price of the bonds. The price of bond instruments depends on economic conditions. When the economy is booming, companies can spend more to cater to the rising demand side. It fuels demand for funds, and companies borrow more, resulting in rising interest rates as demand for credit rises. On the contrary, in a contracting economy, demand for credit goes down as consumers start to spend less. The excess of credit then actually lowers the interest rate. To revive the economy and encourage businesses to avail loans, the government also reduces the lending rate, causing the price of debt instruments to shoot up. Since bond price moves in the opposite direction of the interest rate, a higher long tenure bond requires little funds invested in short tenure bonds, which causes the current rate to fall. Investors begin to anticipate the rates to decline further in the future, which causes the current rates to increase. A similar situation occurred when the pandemic ravaged the nation’s economy last year. But surprisingly, debt mutual funds yielded in the negative, which left many of the investors baffled.
The current situation is unprecedented on several counts, and it had sent the Indian money market into a downward frenzy when COVID-19 cases started to rise in the nation.
During August 2020, most debt funds produced negative returns as sinking GDP and lowered GST collection, along with rising inflation, put pressure on its yield. Foreign portfolio investors were selling heavily in both the debt and money markets, and there was increasing pressure from domestic investors to withdraw from the mutual funds amid rising uncertainties. The supply of funds in the economy also shrunk as banks were trying to keep their NPA low. It reduced the availability of cash in the market. Collectively these factors created a negative situation for the debt funds and impacted the NAV value, which fluctuates daily based on market movements.
Remedies offered by the RBI
Whenever the Indian economy had struggled to find a foothold, RBI, as the central bank, came to the rescue. It was no different in the current scenario. RBI came to the rescue of debt fund investors by purchasing government securities from the market, which increased cash flow in the economy. It also trimmed repo and reverse repo rates to ease the pressure from the banks. Lower interest rates attracted borrowers and normalised the liquidity crunch created by the pandemic. Side-by-side, RBI also increased the supply of the US dollar into the foreign exchange market to strengthen the Indian rupee.
It introduced LTRO or Long-term Repo Operations to encourage banks to invest in bonds and commercial papers to boost the demand for these products. These impacted debt mutual funds and improved NAV.
When interest rates come down in the market, investors start putting their money in the debt fund. But as the economic uncertainties rise, it impacts the creditworthiness of the borrowers. Investors can safeguard their capital by investing in government securities, banking and PSU funds, and corporate bond funds as these are relatively safe since the chances of default are minimum.
Lastly, select a fund based on your risk appetite and investment horizon. If the investment need is immediate you can put the funds in overnight fund or a liquid fund over long-term investment funds.