Debt / Income Funds

Funds that invest in medium to long-term debt instruments issued by private companies, banks, financial institutions, governments and other entities belonging to various sectors (like infrastructure companies etc.) are known as Debt / Income Funds. Debt funds are low risk profile funds that seek to generate fixed current income (and not capital appreciation) to investors. In order to ensure regular income to investors, debt (or income) funds distribute large fraction of their surplus to investors. Although debt securities are generally less risky than equities, they are subject to credit risk (risk of default) by the issuer at the time of interest or principal payment. To minimize the risk of default, debt funds usually invest in securities from issuers who are rated by credit rating agencies and are considered to be of "Investment Grade". Debt funds that target high returns are more risky. Based on different investment objectives, there can be following types of debt funds:

• Bond Funds - Debt funds by nature, bond funds like all mutual funds, are investment vehicles. They are meant especially for investors with relatively less appetite for risk and having an intention to earn returns higher than what are possible to earn from other avenues like Fixed Deposits that are considered as safe. So, safety and return both are of equal concern for those investing in Bond Funds. Most bond funds pay income regularly and their NAVs tend to fluctuate less than an equity fund.
• Diversified Debt Funds - Debt funds that invest in all securities issued by entities belonging to all sectors of the market are known as diversified debt funds. The best feature of diversified debt funds is that investments are properly diversified into all sectors which results in risk reduction. Any loss incurred, on account of default by a debt issuer, is shared by all investors which further reduces risk for an individual investor.
• Focused Debt Funds - Unlike diversified debt funds, focused debt funds are narrow focus funds that are confined to investments in selective debt securities, issued by companies of a specific sector or industry or origin. Some examples of focused debt funds are sector, specialized and offshore debt funds, funds that invest only in Tax Free Infrastructure or Municipal Bonds. Because of their narrow orientation, focused debt funds are more risky as compared to diversified debt funds. Although not yet available in India, these funds are conceivable and may be offered to investors very soon.
• High Yield Debt funds - As we now understand that risk of default is present in all debt funds, and therefore, debt funds generally try to minimize the risk of default by investing in securities issued by only those borrowers who are considered to be of "investment grade". But, High Yield Debt Funds adopt a different strategy and prefer securities issued by those issuers who are considered to be of "below investment grade". The motive behind adopting this sort of risky strategy is to earn higher interest returns from these issuers. These funds are more volatile and bear higher default risk, although they may earn at times higher returns for investors.
• Mortgage-Backed Securities Funds - Mortgage backed securities (MBS) are instruments, which assist HFCs raise funds from the markets, at competitive rates, based on their credit rating. Several HFCs have already issued these securities. Let us understand the basic concept of MBS and how does it work. A mortgage loan is a loan with a physical asset such as real estate, provided as collateral or security. The most common form of mortgage loan is a residential mortgage. Mortgage gives the lender the right to foreclose and seize the property, if the borrower defaults on the loan. This is to ensure that the debt is paid off. MBS are backed/secured by a pool of traditional residential housing loans and are issued/originated by HFCs. They represent an individual ownership in an underlying pool of mortgage loans. Shares of such mortgage pools are then sold in the form of participation certificates.

The interest, scheduled principal payments and prepayments that are collected from the underlying mortgages are passed through to investors after deducting servicing fees. Unlike most fixed income products, MBS are sold and traded based on the average life of the security rather than the stated maturity. The average life is the average time it takes for mortgages in the underlying pool to be ‘paid off’, based on certain assumptions about mortgage prepayment speeds. If prepayment speeds are faster than expected (typical in declining interest rate environment), the average life of the security will be shorter than the original estimate. If prepayment speeds are slower (typical in rising interest rate environment), the security's average life will be extended. Prepayment risk is the significant risk for these securities, as cash flows from the investments cannot be ascertained. Prepayment risk gives these securities a character similar to that of callable securities (eg. bonds issued by IDBI and ICICI) since they can be retired before maturity with no penalty.

In India, HDFC has taken a lead in issuing these securities, followed by slew of HFCs including ICICI Home and Citibank. The following table gives a brief idea about the deals concluded in the past, interest rates at which funds were raised and tenure of the issue.

        Ex. Selected MBS deals

Originator	Amount (Rs m)	Coupon rate	Duration (months)	Mortgage pool *
HDFC	1,560	9.1%	119	NA
ICICI Home Fin	511	8.8%	120	1,639
Citibank	509	NA	84	312
Canfin Homes	582	8.9%	42	4,526

·         Assured Return Funds -Although it is not necessary that a fund will meet its objectives or provide assured returns to investors, but there can be funds that come with a lock-in period and offer assurance of annual returns to investors during the lock-in period. Any shortfall in returns is suffered by the sponsors or the Asset Management Companies (AMCs). These funds are generally debt funds and provide investors with a low-risk investment opportunity. However, the security of investments depends upon the net worth of the guarantor (whose name is specified in advance on the offer document). To safeguard the interests of investors, SEBI permits only those funds to offer assured return schemes whose sponsors have adequate net-worth to guarantee returns in the future. In the past, UTI had offered assured return schemes (i.e. Monthly Income Plans of UTI) that assured specified returns to investors in the future. UTI was not able to fulfill its promises and faced large shortfalls in returns. Eventually, government had to intervene and took over UTI's payment obligations on itself. Currently, no AMC in Indiaoffers assured return schemes to investors, though possible.

·         Fixed Term Plan Series / Serial Schemes - Fixed Term Plan Series usually are closed-end schemes having short term maturity period (of less than one year) that offer a series of plans and issue units to investors at regular intervals. Unlike closed-end funds, fixed term plans are not listed on the exchanges. Fixed term plan series usually invest in debt / income schemes and target short-term investors. The objective of fixed term plan schemes is to gratify investors by generating some expected returns in a short period.

An investor in a debt security gets Investor’s expected yield if Investor holds a fixed coupon debt security until maturity.  But if Investor sells Investor’s security earlier, then what Investor recovers would depend on the market situation at the time of sale.  Investor could equally end up with a capital gain or a capital loss.

Fixed Maturity Plans (FMP) seek to eliminate the risk of such capital loss by investing exclusively in a pre-specified debt security.  Thus, if an investor is desirous of investing for four years, Investor can invest in a  fund that will invest in a pre-specified 4-year security. 

On maturity, the scheme would redeem the security and pay the investor.  The investor, however, can exit earlier.  But what Investor would recover in an early exit would depend on the market situation at Investor’s time of exit. 

Thus, an investor is assured a fixed return, if Investor stays invested in the scheme for the period originally envisaged.  But Investor also has an earlier exit option, in case Investor invests in a FMP that is structured as an open-end scheme.

Normally, an assured returns scheme can be offered only if there is a named guarantor who offers the guarantee.  A FMP is an’ assured returns scheme’ through the back door, since the investor is reasonably assured of the expected return (subject to credit risk and re-investment risk) if Investor holds the units for the originally envisaged period – but the return is assured without a named guarantor.

Further, as explained later in this chapter, mutual funds are tax efficient.  The income accrued in the scheme would not bear a tax, and would therefore be re-invested on “gross basis”.  If the same income were to be received directly by the investor, it would be subject to tax, thus reducing the amount available for re-investment.

When a series of FMPs are issued for different maturities, they are called Serial Funds.  These can choose to invest exclusively in government securities, in which case they become ‘Serial Gilts’.  Alternatively, they can invest in non-government securities, in which case they become ‘Serial Bond Schemes’.

Non-government securities of course have a risk of default (credit risk), which does not exist for government securities.