Debt Funds Explained | Know the Secret to Become Rich
Mutual funds investing is considered to be the milder version of stock market investing, as the mutual fund manager is expected to buy various equity shares as part of his fund if that is an equity mutual fund.
Do you know, debt funds are more popular than the equity mutual funds in the financial world? Also, you’d be surprised to know that equity mutual funds comprise of only 27% of all the mutual funds out there and the lion’s share of remaining 73 % of active funds are debt funds along with other associate mutual fund types.
Another interesting fact to note is that most of HNIs and other corporate Investors prefer the debt funds as their primary choice of investments in the mutual fund sector, which gives them a very healthy returns along with tax benefit. To understand the secret investment strategy of these HNIs on earning good returns and saving lot of taxes, we need to know what debt funds are how can they actually make you rich…
What are debt funds?
By the definition, debt is a process of lending and borrowing money or commodity and during such process the lender always enjoys the perks of interest on the principal amount which the borrower has to pay for borrowing the money.
In mutual fund’s terminology, this interest rate is known as coupon rate and the time frame that money is borrowed is called the tenure of a mutual fund. So, debt funds are a type of mutual funds where the fund manager invests in various debt guarantee papers over a fixed time duration to get a fixed rate of return.
Well.. that being the technical definition of debt funds. Now, Let’s understand this in detail …
What are bonds and who can issue them?
As an individual when we need money, we will try to borrow the required amount from our friends and family agreeing to pay back an interest rate for the sum borrowed. But when a big organization would need money, who will they reach out to?… certainly not their friends and families and also no banks because of higher interest rates and lot of guidelines…
The answer is they borrow from the ordinary citizens for an interest rate by issuing the bonds of that company as a guarantee that they would repay the borrowed money with an interest rate.
Can every company do that?… or in fact who can raise funds like that??
Not everyone can issue debt bonds… In India only below organizations or authorities can issue debt bonds:
Governments
1. Union govt of India (bonds issued by RBI).
2. State governments
3. Local governing bodies (municipalities).
Companies
1. Government companies (NTPC, NMDC etc.)
2. Private companies (Tata etc.)
3. Banks or NBFCs.
How to identify risk and return of a debt bond?
Now that we know, who all can issue debt bonds to raise capital… Is it that the interest rate for all the bonds issued by various companies be same??
The answer is NO …. Generally, the companies that are financially strong tend to have less risk of defaulting the lenders money i.e., there are more chances that lenders money will be paid back by the borrowing entity, so they tend to have lower interest rate.
The companies that are not very financially strong or having some irregularities in the company’s books are those which are considered to be somewhat risky and have higher chances of going bankrupt. Such companies will offer high and, in some cases, very high interest rates to lure the investor for buying their bonds.
Who actually confirms a company’s financial health?
Actually, there are some companies known as rating agencies which are like mainstream media and sort of critics of the financial world, it’s their job to know the published financials of a company and assess their financial health, strengths, and weaknesses of the company and of estimate the risk status of the bonds issued by that company. The companies which assess are known as credit rating agencies.
CRISIL, ICRA, CARE are some of the credit rating agencies.
Bonds, with the tenure time under 1 year are known as short term bonds and those with the
tenure greater than 1 year are known as long term bonds. Let’s look at the ratings of some long-term bonds by these credit rating agencies
AAA, Care AAA, LAAA —> Highest rating, which depicts that the chances of the company being default is almost 0.
AA, Care AA, LAA —–> Second highest rating.
Subsequently, goes doing with the ratings like B, C
D, Care D, LD —> Lowest rating, which stands for ‘Default’, which means the company has defaulted the lenders money and the chances of getting back lender’s money is 0.
Now, let’s take a look at the short-term bond ratings
P1, PR1, A1 –> Highest rating that suggests company has less chances of default.
P5, PR5, A5 –> Lowest rating and high chances of company going broke.
Based on the company’s performance and the financials the rating of the companies can change from time to time.
Conclusion
Now that we know what actually debt instruments are, we can now relate to what are debt funds i.e., the mutual funds that invest into or buy the debt bonds or papers of various companies are known as debt funds.
Now, after understanding the basics of debt funds. If you are planning to invest in one, it’s more important to know in all the bonds into which the fund manager is investing the money into. As there are chances that the fund manager buys those bonds with not a good credit rating, but the return rate of the mutual fund is high compared to other mutual funds of the same category, you might be attracted towards investing into such funds.
In such a scenario… it’s always better to proceed with the mutual funds that are investing into bonds with a good credit rating with a moderate return over the risky ones with high returns, as with the latter there is always a risk of losing all of your money if the issuing company defaults overnight.
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