The debt part of the portfolio is to provide stability to the portfolio, not to generate a higher return. If investors want a higher return from their portfolio, they should ideally increase equity allocation in the portfolio. (View Highlight)
Employee Provident Fund (EPF), Public Provident Fund (PPF) and Sukanya Samriddhi Yojana (SSY) are the best products for the debt part of the long-term portfolio for retail investors.
Investors should use debt mutual funds in their long-term portfolios only after the optimum use of EPF, PPF and SSY. Investors can use debt funds to maintain some liquidity in their long-term portfolios. (View Highlight)
Investors can safely use bank fixed and recurring deposits if they require the amount within three years. There is no tax benefit in debt funds as against bank fixed deposits if all the amount is redeemed within three years. (View Highlight)
Here are the benefits of debt mutual funds over bank fixed deposits, company fixed deposits and individual bonds. (View Highlight)
You can deposit money and withdraw whenever you want. You can choose how much money to deposit and withdraw. (View Highlight)
Unlike fixed deposits, in debt funds, you pay tax only when you withdraw. Because of the deferred tax, all the gains in debt funds are available for compounding. The impact of this over 15 years is huge if debt funds generate the same return as bank fixed deposit interest rates. (View Highlight)
Debt funds provide better diversification and reduce single-entity risk in the portfolio. (View Highlight)
There are majorly two types of risks in debt mutual funds; credit risk and interest rate risk. (View Highlight)
Credit risk is the possibility of loss resulting from the default of bonds in debt mutual fund portfolios. To analyse the credit risk in a debt mutual fund, retail investors have no option but to rely on credit ratings. (View Highlight)
A credit rating represents the rating agency’s current opinion on the probability of default or the likelihood of the principal and the interest not being repaid in full and on time. The highest credit rating doesn’t mean a guarantee against default. (View Highlight)
Securities issued directly by RBI and the Government of India are the safest and the highest quality in the Indian context. This is because of the government’s ability to raise taxes and print money to meet its Indian rupee-denominated obligations. Government securities are not rated by rating agencies. In debt fund portfolios, their rating is shown as SOV. (View Highlight)
The table below lists credit rating symbols and what they mean. The long-term scale is for debt instruments with an original maturity of over one year, while the short-term scale is for instruments with an original maturity of one year or less. (View Highlight)
A ‘+’ (plus) or ‘-’ (minus) sign is attached to reflect a comparative higher or lower standing within each category. (View Highlight)
Ratings of shorter-duration bonds are more reliable than ratings of longer-duration bonds. This is because forecasting revenue that will be dedicated to paying principal and interest on the bond being rated over the next six months or perhaps one year is relatively easy. Still, the further one predicts the future, the more imprecise and unreliable forecasts become. (View Highlight)
Ratings are revised to default (D) at the first instance of the first rupee default. A delay of 1 day, even 1 rupee (of principal or interest) from the scheduled repayment date, is considered a default. A default rating does not imply that there are no recovery prospects. (View Highlight)
Defaulted bonds usually have some salvage value; therefore, even when defaults occur, bonds seldom lose 100% of their value. (View Highlight)
The more creditworthy issuers like the government and blue chip companies with little debt borrow at a lower cost. Less creditworthy issuers have to pay higher interest. (View Highlight)
Higher the yield of the bond, the higher the credit risk. (View Highlight)
When a bond is downgraded, the price of the bond declines, whereas if the rating is upgraded, the bond’s price appreciates. The change in the price corresponds to the amount required to bring the bond yield in line with other bonds rated at the same level. (View Highlight)
Unless there is a significant risk of default, price changes because of upgrade or downgrade of bonds is small. (View Highlight)
Retail investors should prefer debt funds that invest most of the portfolio in SOV, AAA, AA, and A1-rated debt instruments. (View Highlight)
A high rating does not mean that the default won’t happen, but the probability of default for higher-rated papers will always be lower than those for lower-rated papers. (View Highlight)
Bond prices change in response to changes in interest rates. These fluctuations in bond prices due to changes in interest rates are referred to as interest rate risk. (View Highlight)
Suppose you bought a 3-year bond that shall pay you 8% interest. Further, suppose at a later date, you wish to sell this bond when interest offered on the similar new bond is 10%. No buyer will purchase your bond yielding 8% when he has an option of purchasing a similar new bond yielding 10%. You must reduce the price of your bond and sell it at a price where the buyer gets a 10% yield on your bond. Likewise, you would sell the bond at a higher price if the yield on a similar new bond is 6%. (View Highlight)
The fundamental principle is that interest rates and prices of bonds move in opposite directions. If interest rates rise, the bond price declines, and when interest rates decline, the bond price goes up. (View Highlight)
Higher the maturity length, the higher the fluctuations in the bond price because of interest rate changes. If interest rates rise, the value of bonds with maturities under a year changes only slightly. Each additional year in maturity adds some degree of volatility. (View Highlight)
