Debt mutual funds offer risk-free returns

Debt mutual funds offer risk-free returns
Highlights

Debt market comprises of various debt instruments from short term Treasury bills (T-bills) to Commercial Paper to Company Deposits to Corporate Bonds to Government Securities fairly in the order of their holding period.

Debt market comprises of various debt instruments from short term Treasury bills (T-bills) to Commercial Paper to Company Deposits to Corporate Bonds to Government Securities fairly in the order of their holding period.

Debt markets are used to raise capital by the various players like governments, institutions, corporations, etc., similar to that of the equity.

The biggest difference, however, is that each bond has a maturity i.e. time when the principal is repaid, and the interest earned i.e. a percentage of the capital is paid out on a periodic basis also known as coupon.

Debt instruments like bonds are nothing but promissory note issued by corporates/institutions instead of individuals.

Government Securities (G-Secs) are also bonds but are issued by the Government and carry sovereign guarantee but are usually long-term in nature.

Within the Government Securities, there are bonds issued by the State governments, local municipalities, State owned corporations, quasi-government institutions, etc.

Most of these bonds also carry the sovereign guarantee are so seen as protection against any defaults.

The only difference is that these bonds unlike our promissory notes are tradable i.e. are listed on the exchanges and change hands.

Most of the large financial institutions (like banks, mutual funds, insurance companies, etc) usually are the hoarders of these bonds partly due to their regulatory obligations or for the longer-term maturities which help for their cash flow requirements.

Each bond carries an interest or coupon which the bond issuer guarantees the bondholder for the entire period of the bond while the periodicity of interest payment would vary with the issuer.

A sovereign guarantee bond would put the coupon at a discount to the market rate due to the associated security against a default. Some of the corporate bonds are issued with a security backed up to the raised loans and others are issued as unsecured debt.

The coupon on the bond is dependent upon the corporation or institution raising, the purpose of the capital raising exercise, the secured or unsecured nature of the issue, the issuers financials and the overall market conditions.

Depending upon the prevailing market conditions even an unsecured debt would be lapped up by the investors who are willing to take higher risk for an incremental return. The yields on these bonds depend upon the overall liquidity in the market and also on the general performance of the company.

The yield on the bond is the calculation of interest earned upon the price of the bond. As the coupon is defined at the beginning of the issue, it remains constant, but the bond price fluctuates depending upon the demand and supply.

The liquidity pressure could create stress on the bond prices too. So, when there is an increase in the broader interest rates, there is a less demand to the existing bonds with relatively lower interest rate leading the bond prices to fall and vice versa.

Whenever the bond prices fall, as the interest earned is same (coupon is fixed on the issue price or face value) the yield on the bond would be higher and when the bond prices harden up and with the interest earned remaining same, the yield on the bond would be lower. This is the reason bonds and debt market in general are prone to interest rate risks.

The purpose of capital, the company financials, the sector, the overall company or group standings, debt-equity structure, the interest coverage ratio (i.e. the capacity to service the loan) and the solvency ratios along with the overall market conditions, government regulations/policies and the general liquidity in the system are considered when the rating is done on each bond.

This is done by independent Credit Rating Agencies which evaluate on a regular basis and instill the rating to these bonds. These ratings form the cornerstone for the risk evaluation for decision making by the investors.

A better rated debt paper is subscribed higher at the primary issue and also the demand remains high even in the secondary market.

Debt mutual funds invest in these instruments which have short to long tenures for maturity with low to high coupon depending upon the ratings.

Recent fiascos in the debt space has reduced conviction among the retail investors in debt funds but the current market is attractive at almost all maturities relative to the long-term averages.

After a detailed analysis and need based exposure to debt mutual funds would not only provide insulation to equity risks but also derive better risk adjusted returns to the portfolios.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)

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