In the upcoming chapters, we will be familiarising ourselves with the basics of debt mutual funds. As was discussed in the previous chapters, there are a large variety of debt fund types – but typically, a retail investor only needs a few. Henceforth, we shall focus on these important topics:
Ultrashort term funds
Banking & PSU
GILT funds (2 different types)
Debt funds, liquid and overnight funds make up almost half of the mutual fund industry’s 27 lakh crore AUM (as of January 2020). This is a significant amount of investor money, and debt funds play an important role in any portfolio due to their capital protection abilities.
To comprehend debt, it is essential to understand its source. For example, let us look at a common debt structure which is familiar to us, whether from personal experience or observations.
To start with, suppose you are in the market for an apartment.
After an exhaustive search, you eventually spot your desired apartment. It comes with all the amenities that you could have possibly asked for – swimming pool, clubhouse, convention centre, supermarket, and even a tennis court. You will need to pay 1.5Cr in total for the property but luckily you have 40L stashed away which covers the down payment. Now the question is: how can you get hold of the additional 1.1Cr?
You may go to a bank and ask for a loan. After examining your application, the institution will either grant you the amount requested or reject it. Before taking such an important decision, the bank will do some thorough research about you. A crucial factor that can determine this is your credit score given by companies like CIBIL or Experian. This metric is indicative of your financial reliability; the higher it is, the more likely you are to be approved for a loan with a good interest rate. However, if it is low, you might find yourself in a bind.
Let us just suppose that you have an impressive credit rating, and the bank chooses to give you a loan of 1.1Crore for your apartment purchase. The specifics of your loan are:
Credit score: 850
Amount : Rs.1,10,00,000/-
Tenure: 10 years or 120 months
Interest rate: 8.5%
Total interest payable : Rs.53,66,129/-
Total payable (Int + Principal) : Rs.1,63,66,129/-
Monthly EMI: Rs.1,36, 384/-
You can use various online calculators to get the details you need. I’ve tried the one offered on Bajaj Finserv’s page, but note that your credit score is arbitrary here.
This agreement contains all the relevant details, terms and conditions, and has been stamped with a paid stamp duty. After both parties put their signatures on the document, it is officially registered and referred to as a loan agreement.
Once the loan has been granted, the bank will credit the money to your account. Your property will remain as collateral in case of any default on your part; if you fail to pay back the sum borrowed, the bank can sell it off and recover their principal with interest.
From the bank’s point of view, the loan is secured against something valuable, such as property, making it a ‘collateralized loan’. This type of loan is a much safer bet for the bank than those that are not collateralised.
At this juncture, I want you to understand the formation of a debt obligation. This occurs when someone requires financing for an economic activity that exceeds what they have available.
Assuming the process goes well, each month for the next decade, the borrower is expected to pay a total of Rs.1,36, 384/- to the bank. This consistent income will be considered their ‘cash flow’.
So far, things are looking good and this debt structure is relatively understandable. Now, we should consider the risks that worry the banker who lends the money. What do you believe would be the foremost cause of concern for them?
There are a few issues that could arise.
Cash Flow risk – The borrower may miss a few repayments, which can lead to less cash flow than expected for the bank. This could spark off a series of unfortunate consequences.
Default risk – Default is a risk associated with borrowing, whereby the borrower may become insolvent and unable to meet loan obligations. In such a situation, repaying the loan becomes a challenge for the borrower who may ultimately decide not to repay.
Interest rate risk – Interest rate risk is present when a loan is given at a specific rate, yet the economic environment may evolve and result in lower rates. This could lead to the bank being forced to decrease rates and diminish the anticipated cash flow.
When a loan is given, the bank assesses the borrower’s credit score. It may be high initially, but might decline unexpectedly, thus increasing the probability of defaulting.
Asset risk – In the case of a borrower defaulting, the bank has the authority to sell the collateral. However, if the asset itself loses value, this would be a huge blow to the lender or bank. In such a situation, they would not only lose the loan capital but also forfeit their security.
The example of a bank and an individual is there. The same risks, however, apply to corporate entities as well. Debt obligations bring risks that are encountered regularly.
The manufacturing company can obtain the INR 800 Crores they need to build their new plant through two different routes. They could take out a loan, or they could seek investment from sources outside the company.
Speak to a bank about getting a loan, similar to the apartment situation we discussed.
Rather than approaching a bank for funding, the company can opt to raise a lesser sum from numerous investors, potentially in several lots of twenty crores. These investors will be repaid with interest as opposed to the bank.
If the company opts for a loan from the bank, they will be bound by a ‘loan agreement’, whereas if they look to numerous lenders, then the legally binding contract is called a ‘bond’.
A bond is a promise from a company to its investors or lenders to repay the principal at the end of its tenure, with periodic interest payments known as coupons.
I understand that this is not the typical way of introducing the idea of ‘bond’, but I trust you have grasped it. Essentially, a bond is a financial instrument; where someone who has more money than they need lends capital to someone who needs it. In exchange for this, the creditor is paid interest and then the full principal amount when the term expires.
It’s that easy.
The potential mentioned in the bank-apartment example is just as relevant with bonds. There are three major perils that investors must keep in mind when dealing with them –
Interest rate risk
Now that we have a good grasp of what bonds are, the associated risk (in short) and their fundamentals, let us delve into understanding more about debt funds.
One thing to keep in mind is that investing in debt funds and trading bonds are two separate activities. Mutual fund investors should only focus on three factors:
When should you put your money in a debt fund, and what criteria should you use to pick one?
What a particular category of debt fund does
The risk associated with that category of debt fund
The fund manager of the debt fund should take caution when investing or trading in the bond market.
The bond market is an expansive venue, both domestically and globally. Companies often turn to bonds as a means of securing capital and have investors support such transactions.
The mutual fund firms invest in bonds issued by companies which have a financial need.
Now that we have this information, let’s take a look at the various kinds of debt funds.