DEBT – INCOME INVESTMENTS

Debt Instruments are obligation of issuer of such instrument as regards certain future cash flow representing Interest & Principal, which the issuer would pay to the legal owner of the Instrument. Types of Debt Instruments are of different types like Bonds, Debentures, Commercial Papers, Certificates of Deposit, Government Securities (G – Secs) etc. The Government Securities (G-Secs) market is the oldest and the largest element of the Indian debt market in terms of market capitalization, trading volumes and outstanding securities. The G-Secs market plays a very important role in the Indian economy as it provides the benchmark for determining the level of interest rates in the country through the yields on the government securities which are treated as the risk-free rate of return in any economy.

An investor invests in fixed income bearing instruments based on following criteria:

  • Returns expected
  • Risk associated with the investment
  • Tenure of the investment
  • Volatility in returns
  • Predictability of returns

The various types of fixed income instruments are outlined below:

Fixed Deposits / Certificate of Deposit

The term “fixed” in Fixed Deposits denotes the period of maturity or tenure. Fixed Deposits are also known as Term Deposits and FDs. In a Fixed Deposit, money is deposited in the bank / institution for a specified period of time earning a fixed rate of interest. The bank / institution pays interest on the money deposited with them. They are different from savings accounts in that the CD has a specific, fixed term (often 3 months, 6 months, or 1 to 5 years), and, usually, a fixed interest rate. It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.

In case of an emergency, you can make a premature withdrawal or break your Fixed Deposit by paying a penalty. The depositor will be given 1% less interest on withdrawal.

Advantages of Fixed Deposits

  • Fixed Deposits offer fixed and guaranteed returns.
  • FDs are liquid investments. You can withdraw whenever you need cash, just by paying a penalty.
  • Fixed deposits are flexible in nature. You can opt for an FD whose maturity can range from 1 month to 1 year to even 10 years.
  • You can invest small amounts in an FD.
  • It is easy to raise a loan against an FD. You can borrow up to 90% of the FDs amount, just by pledging the FD.

Disadvantages of Fixed Deposits

  • Returns are lower than many other investment options.
  • FD interest is not sufficient to cover rising inflation.
  • If borrowers invest all their savings in FDs, they may not enjoy the benefits of portfolio diversification like investments in shares, Mutual Funds and real estate.
  • TDS is deducted on interest income.
  • Premature withdrawal results in loss of interest income in the form of a penalty.

Investor Profile:

  • RISK – Conservative
  • RETURN – Low
  • TENURE – Low / Medium
  • VARIABILITY – Low
  • PROBABILITY OF RETURN – Very high

A Bond is simply an ‘IOU’ in which an investor agrees to lend money to a company or government in exchange for a predetermined interest rate. If a business wants to expand, one of its options is to borrow money from individual investors. The company issues bonds at different interest rates and sells them to the public. Investors purchase them with the understanding that the company will pay back their original principal with some interest that is due by a set date (this is known as the “maturity”). The interest a bondholder earns depends on the strength of the corporation.

For example, a blue chip is more stable and has a lower risk of defaulting on its debt. Sometimes some big companies issue bonds and they may only pay 7% interest, but some other small companies may pay you 10%. A general rule of thumb when investing in bonds is that “the higher the interest rate, the riskier the bond.”

There are many types of bonds, each having diverse features and characteristics. Bonds and stocks are both securities, but the major difference between the two is that stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.

Returns in Bonds Returns is depends on the nature of the bonds that have been purchased by the investor. Bonds may be secured or unsecured. Firstly, always check up the credit rating of the issuing company before purchasing the bond. This gives you a working knowledge of the company’s financial health and an idea about the risk considerations of the instrument itself. Interest payments depend on the health and credit rating of the issuer. Therefore, it is essential to check the credit rating and financial health of the issuer before loosening up the bond. If you do invest in bonds issued by the top-rated Corporates, there is no guarantee that you will receive your payments on time.

Risks in Bonds In certain cases, the issuer has a call option mentioned in the prospectus. This means that after a certain period, the issuer has the choice of redeeming the bonds before their maturity. In that case, while you will receive your principal and the interest accrued till that date, you might lose out on the interest that would have accrued on your sum in the future had the bond not been redeemed. Always remember that if interest rates go up, bond prices go down and vice-versa.

Debenture

A debenture is similar to a bond except the securitization conditions are different. A debenture is generally unsecured in the sense that there are no liens or pledges on specific assets. It is defined as a certificate of agreement of loans which is given under the company’s stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the principal amount whenever the debenture matures.

In finance, a debenture is a long-term debt instrument used by governments and large companies to obtain funds. The advantage of debentures to the issuer is they leave specific assets burden free, and thereby leave them open for subsequent financing. Debentures are generally freely transferrable by the debenture holder. Debenture holders have no voting rights and the interest given to them is a charge against profit

Commercial Papers

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. It was introduced in India in 1990 with a view to enable highly rated corporate borrowers/ to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations. CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value). It will be issued foe a duration of 30/45/60/90/120/180/270/364 days. Only a scheduled bank can act as an Issuing and Paying Agent IPA for issuance of CP.

Features of Commercial Papers

Following are the important features of commercial papers

  • They are unsecured debts of corporates and are issued in the form of promissory notes, redeemable at par to the holder at maturity.
  • Only corporates who get an investment grade rating can issue CPs, as per RBI rules.
  • It is issued at a discount to face value
  • Attracts issuance stamp duty in primary issue
  • Has to be mandatorily rated by one of the credit rating agencies
  • It is issued as per RBI guidelines
  • It is held in Demat form
  • CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by a single investor should not be less than Rs.5 lakh (face value).
  • Issued at discount to face value as may be determined by the issuer.
  • Bank and FI’s are prohibited from issuance and underwriting of CP’s.
  • Can be issued for a maturity for a minimum of 15 days and a maximum upto one year from the date of issue.

Investor Profile:

  • RISK – Conservative
  • RETURN – Low / Medium
  • TENURE – Low / Medium
  • VARIABILITY – Low
  • PROBABILITY OF RETURN – Very high

FMP – Fixed Maturity Plans

FMP (or Fixed Maturity Plan) is a closed-ended debt mutual fund. Such a fund invests only in instruments whose duration is similar to its own term i.e., it aligns its term with that of its underlying assets. For example, a 1115-Day FMP would invest in instruments that mature in 1115 days or slightly before that.

Such synchronization done to eliminate the risk of interest rate fluctuation (usually faced by debt funds). This scheme is apt for investors who seek stable returns from a debt investment.

What is in it for the investor?

Long-term FMPs (held for a period of 36 months or more) are an ideal investment avenue for investors who:

  • Need capital protection
  • Want to take a minimum exposure to market risk
  • Wish to park funds for a long-term goal
  • Wish to avail double indexation benefit – tax benefit over FD’s
  • Earn a steady return on investment

The FY-15 union budget has changed the taxation rules for non-equity mutual funds like FMPs. Accordingly, short term capital gains (one and two-year FMPs) will be taxed at 30% (assuming the investor falls into the highest tax bracket).

Investor Profile:

  • RISK – Conservative
  • RETURN –Medium
  • TENURE – Medium
  • VARIABILITY – Low
  • PROBABILITY OF RETURN – Very high

DEBT MUTUAL FUNDS

There are different types of Mutual Funds that invest in various securities, depending on their investment strategy.

Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest.

The returns of a debt mutual fund comprises of –

  • Interest income
  • Capital appreciation / depreciation in the value of the security due to changes in market dynamics

Debt securities are also assigned a ‘credit rating’, which helps assess the ability of the issuer of the securities / bonds to pay back their debt, over a certain period of time. These ratings are issued by independent rating organisations such as CARE, CRISIL, FITCH, Brickwork and ICRA. Ratings are one amongst various criteria used by Fund houses to evaluate the credit worthiness of issuers of fixed income securities.

There is a wide range of fixed income or Debt Mutual Funds available to suit the needs of different investors, based on their:

  • Investment horizon
  • Ability to bear risk

Investor Profile:

  • RISK – Medium / High
  • RETURN –Medium / High
  • TENURE – Medium / High
  • VARIABILITY – Low / High
  • PROBABILITY OF RETURN – Medium / High

TYPES OF DEBT MUTUAL FUNDS

There are different types of Debt Mutual Funds that invest in various fixed income securities of different time horizons. Some of the debt based & blended category products (which have both debt and equity allocation) are as follows –

Liquid Funds / Money Market Funds

These funds invest in highly liquid money market instruments and provide easy liquidity. The period of investment in these funds could be as short as a day. They aim to earn money market rates and could serve as an alternative to corporate and individual investors, for parking their surplus cash for short periods. Returns on these funds tend to fluctuate less when compared with other funds.

Ultra Short Term Funds

Earlier known as Liquid Plus Funds, they invest in very short term debt securities with a small portion in longer term debt securities. Most ultra short term funds do not invest in securities with a residual maturity of more than 1 year. Also referred to as Cash or Treasury Management Funds, Ultra Short Term Funds are preferred by investors who are willing to marginally increase their risk with an aim to earn commensurate returns. Investors who have short term surplus for a time period of approximately 1 to 9 months should consider these funds.

Floating Rate Funds

These funds primarily invest in floating rate debt securities, where the interest paid changes in line with the changing interest rate scenario in the debt markets. The periodic interest rate of the securities held by these products is reset with reference to a market benchmark. This makes these funds suitable for investments when interest rates in the markets are increasing.

Short Term & Medium Term Income Funds

These funds invest predominantly in debt securities with a maturity of upto 3 years in comparison to a Regular Income Fund. These funds tend to have a average maturity that is longer than Liquid and Ultra Short Term Funds but shorter than pure Income Funds. These funds tend to perform when short term interest rates are high and could potentially benefit from capital gains as liquidity comes back to the market and interest rates go down. These funds are suitable for conservative investors who have low to moderate risk taking appetite and an investment horizon of 9 to 12 months.

Income Funds, Gilt Funds and other dynamically managed debt funds

These funds comprise of investments made in a basket of debt instruments of various maturities & issuers. These funds are suitable for investors who willing to take a relatively higher risk as compared to corporate bond funds,and have longer investment horizon. These funds tend to work when entry and exit are timed properly; investors can consider entering these funds when interest rates have moved up significantly to benefit from higher accrual and when the outlook is that interest rates would decrease. As interest rates go down, investors can potentially benefit from capital gains as well. A few types of dynamically managed debt funds. are mentioned below –

Income funds invest in corporate bonds, government bonds and money market instruments. However, they are highly vulnerable to the changes in interest rates and are suitable for investors who have a long term investment horizon and higher risk taking ability. Entry and exit from these funds needs to be timed appropriately. The correct time to invest in these funds is when the market view is that interest rates have touched their peak and are poised to reduce.

Gilt Funds invest in government securities of medium and long term maturities issued by central and state governments. These funds do not have the risk of default since the issuer of the instruments is the government. Net Asset Values (NAVs) of the schemes fluctuate due to change in interest rates and other economic factors. These funds have a high degree of interest rate risk, depending on their maturity profile. The higher the maturity profile of the instrument, higher the interest rate risk.

Dynamic Bond Funds invest in debt securities of different maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the interest rate view of the fund managers. These funds Invest across all classes of debt and money market instruments with no cap or floor on maturity, duration or instrument type concentration.

Corporate Bond Funds

These funds invest predominantly in corporate bonds and debentures of varying maturities that offer relatively higher interest, and are exposed to higher volatility and credit risk. They seek to provide regular income and growth and are suitable for investors with a moderate risk appetite with a medium to long term investment horizon.

Close Ended Debt Funds

Fixed Maturity Plans (FMPs) are closed ended Debt Mutual Funds that invest in debt instruments with a specific date of maturity that is less than or equal to the maturity date of the scheme. Securities are redeemed on or before maturity and proceeds are paid to the investors.

FMPs are similar to passive debt funds, where the portfolio manager buys and holds the debt securities for the entire duration of the product. FMPs are a good option for conservative investors, as they do not carry any interest rate risk provided the investor stays invested until the maturity of the product. They are also a tax efficient investment option.

Hybrid Funds

They bridge the gap between equity and debt schemes by investing in a mix of equity and debt securities. This adds a considerable amount of risk to the product and will suit investors looking for commensurate returns with higher levels of risk than regular debt funds.

Monthly Income Plans (MIPs) strive to offer the benefit of diversification across asset classes by investing a proportion of the portfolio in debt securities (70% to 95%) with a smaller allocation in equity securities (5 % to 30 %).

As the correlation between prices of equity and debt is low, this product endeavors to give an investor returns that are relatively higher than debt market returns. MIPs can be classified as debt oriented hybrids that seek to –

  • generate income from the debt securities
  • maximise the benefits of long term growth from equity securities
  • aim for periodic distribution of dividends

However, an important point to be noted is that monthly income is not assured and it is subject to the availability of distributable surplus in the fund.

Capital Protection Oriented Funds are closed ended funds that are hybrid in nature; they allocate money to debt and equity securities. The allocation to debt securities is done in such a way that at the end of the term of the product, the value of debt investment is equal to the original investment in the fund. The equity portion aims to add to the returns of the product at maturity. These funds are oriented towards protection of capital and do not offer guaranteed returns.

Say, for example, AAA bonds are quoting at interest rate of 10% p.a. for a 5 year term.

  • This means that at the end of 5 years, the investment of Rs. 100 in such bonds would be worth Rs. 161.05, assuming reinvestment of the interest.
  • On the other hand, if one invests Rs. 62.09 in such bonds, the value of the bonds at the end of 5 years would be Rs. 100.

In such a case, the allocation between equity and debt would be 38 : 62 respectively. So, if the equity value reduces to zero, the investor gets back the original amount invested.

The asset allocation is a function of prevailing interest rates on high quality (AAA rated) bonds. It is mandatory for the fund to be rated by at least one rating agency in order to be called a capital protection oriented fund. Debt securities held in the portfolio must be of highest rating.

Multiple Yield Funds are close ended income funds that aim to optimize income from debt securities and potential growth from equity. They aim to limit the downside by investing in rated debt instruments of reputed issuers. Through a limited equity exposure, they aim to provide capital appreciation by investing in shares of companies without any sector or market capitalization bias. This exposure will help to participate in the growth of these companies thus seeking to provide the portfolio with an element of potential long term capital appreciation.

Benefits of investing in Debt Mutual Funds

The various benefits of investing in Debt Mutual Funds are listed below –

  • Your investments are not affected by equity market volatility
  • Add stability to your investment portfolio
  • Freedom to withdraw your money when required
  • You can aim for better post tax returns

Structured products

Structured products (SP) are a wealth creation and portfolio protection tool. These products are designed to produce returns on the basis of the performance of the underlying security – Nifty, single stock, bouquet of stocks or GSEC etc.. Although, it is rigid, traditional cousins — non-convertible debentures came with fixed coupons. Today, due to financial engineering, their performance can be linked to Nifty or any other security. Due to this evolution, SP can be designed in a zillion ways to generate returns across various market moods through flexible coupons.

Structured products are composed of fixed income and derivative components. Derivatives are quite a notorious lot in the investment world. It takes professional designing to tame this investment vehicle and reap its benefits through effective risk management. The significant combination allows the product to maximize the probability of generating expected returns while keeping the risk level in check.

It is available in principal protected, partial-principal protected and non-principal varieties. Its behaviour in terms of aggression and return generating ability can be used to classify them into debt and equity varieties. We’ll learn more about this in the upcoming articles.

Investor Profile:

  • RISK – High
  • RETURN –Medium / High
  • TENURE – Medium / High
  • VARIABILITY – Low / High
  • PROBABILITY OF RETURN – Low / Medium