What is Debt? What are its features?

Debt in simple words means ‘a sum of money that is owed or due’

Some of the common features of Debt are:

• Principal
• Tenure
• Interest (or some places also called coupon)
• Credit Rating

Let’s take some examples

Example 1:

Mr. Ram goes to his bank to make a Fixed Deposit. He makes the deposit of Rs. Ten Lacs for a period of 36 months at the interest rate of 8.00% p.a.

This means now his bank owes Mr. Ram a sum of Rs. 10 Lacs with interest, to be paid in 3 years.

Example 2:

Mrs. Kanta went and opened a PPF account in the nearest post office. The tenure is 15 years by default and a deposit of Rs. 1.5 Lacs was made. The government fixes the rate at 8.50% (changeable every year).

This means Government of India (through post office) now owes Mrs. Kanta the sum of Rs. 1.5 Lacs at the interest rate of 8.50% p.a.

Example 3:

Mr. Pramod bought a long-term bond of Edelweiss Financial Services. The investment was 10 Lacs and the tenure was 10 years. The coupon rate was 9.75%.

Edelweiss owes Mr. Pramod a sum of 10 Lacs at the end of 10 years and at an interest rate of 9.75% p.a.

Let us now look at various type of Debt instruments:

• Fixed Deposit
• Public Provident Fund (PPF)
• Bonds (issued by both Government and Companies)
• Debt Mutual Funds
• National Savings Certificate
• Debentures

What are Debt Funds?

The picture below shows the different kinds of Debt Mutual Funds available for investors. 

Debt funds are a vehicle to participate in some of the Debt instruments like Corporate Bonds, Certificate of Deposits (bank FD’s issued to Institutional Investors), Government Bonds, Debentures, etc.

Debt funds pool in the money from various investors and invest in the above-mentioned debt securities.

The key terms to be known while investing in Debt Mutual Funds:

What are the key terms used in Debt Mutual Funds?

Key terms to be used in Debt mutual funds

1. Type of Debt Funds: there are debt funds for each investor need, right from parking money for a couple of days to creating a long-term strategic debt portfolio

The classification as prescribed by the regulatory is as follows

What are the various types of Debt Funds?

1. Yield to Maturity (YTM): YTM is the weighted average interest rate that a debt mutual scheme carries on its current portfolio
2. Average Maturity: This is the weighted average time period in which the securities held in the debt fund, will mature. This doesn’t mean the portfolio will end after that. It suggests the tenure of the portfolio and can be used to assess suitability (explained later in the article)
3. Expense Ratio: This is the per year cost that the fund will deduct (daily pro-rata basis) from the unit price

What are the risks involved in investing in Debt Funds?

Now lets us look at the major risks associated with debt funds:

1. Interest Rate Risk: The bond prices are inversely proportionate to interest rates. Increase in Interest rates push the prices of the bonds downwards and decrease in interest rates can push the prices of bonds upwards. The maturity period of the bond also impacts the sensitivity of the bond towards any change in the interest rates. Longer the tenure, higher will be the sensitivity of the bond
2. Credit risk (default risk): Debt funds invest in corporate bonds with various ratings from AAA+ to BBB+. The lower the rating, the higher will be the interest offered by the corporate. There are various rating agencies who use their own methodologies to rate various bonds. Ratings can also change with the period of time. Any rating upgrade is positive for the fund and any rating downgrade is negative for the fund.
3. Reinvestment Risk: This is not much spoken about but is also an important aspect to take note of. Sometimes, due to market conditions the short-term rates go up and the funds to take advantage invest in those. The problem with the strategy is that the fund may not find appropriate securities after the portfolio matures and if the time horizon of the investor is long, he may not be best served in this case

Benefits of Debt funds

1. Debt funds allow you to participate in the debt market instruments, which otherwise require larger capital
2. Unlike the FD’s, you are not required to pay tax on accrual. You only need to pay taxes once you sell the Debt Fund
3. There is a lower tax on Debt funds, if held for 36 months or more
4. Debt fund allow you to diversify your debt allocation amongst large number of securities
5. Debt funds earn you pro-rata returns unlike an FD. For example, if you make a FD of 1 year and break it in 5 months, you will be given the 5-month rate (which could be lower) and some penalty too maybe applied. In a Debt fund, you can take the return up to date
6. Market returns can possibly be much higher than a fixed rate because there is usually a reward for the risk taken

Experience of investors has been mixed and to make the experience better, investors should match the fund with their necessity and goal.

The above article may miss out some points but tries to highlight some of points which investors may find useful.