It’s easy to understand where equity funds invest and how they generate returns. They buy and sell equity shares. When share prices go up, equity funds generally tend to gain.
But debt markets work differently. To put it simply, it’s a market place for borrowers to borrow money and lenders who are willing to lend. Timely payment of interest and principal is crucial. And because retail investors usually cannot buy them directly (face value of one bond is typically around Rs 1 lakh), there is little understanding on how such debt instruments work.
Where do short-term debt funds invest?
Typically, such funds invest in instruments that mature within a year. They include TREPS (Tri-Party Repo), repurchase agreements (repo), Certificates of Deposits (CDs), Commercial Papers (CPs), T-bills and so on. Banks, Non-banking finance corporations (NBFCs), PSUs, corporates and the Government issue such money market instruments to meet their short-term funding requirements.
Repo and TREPS are the instruments used to provide loan for the very short term of, say, overnight or up to a year. Repo allows institutions such as banks and NBFCs to borrow funds by putting up government securities as collateral. These firms can also lend in the repo market. Interestingly, mutual funds can only lend in the repo market (barring extreme conditions).
To vitalise the debt market, the RBI recently allowed repos to be backed by corporate bonds as collateral.
Interestingly, even equity funds park their short-term surplus in the repo market.
Short-term debt funds also invest in CDs, CPs and T-bills. These are also instruments that allow the borrowers – banks and corporates – to borrow for their short-term needs. Banks issue CDs, corporate firms issue CPs and the government issues T-bills through the RBI. Typically, CDs are rated higher than CPs and come with better credit quality. That is also why CPs come with slightly higher interest rates to compensate for their sometimes lower credit rating.
Most of these instruments are zero-coupon bonds, which are issued with discounts. For instance, a three-month T-bill of Rs 100 (face value) may be issued at say Rs 98, that is, at a discount of Rs 2. At maturity, the issuer repays the face value of Rs 100. So, the return to the investors is Rs 2.
While short-term debt funds invest a significant chunk of their corpus in such avenues, long-term debt schemes too invest a sizeable portion. But short-term debt instruments give far lower returns, as can be seen from the chart.
Where do long-term debt funds invest?
Government securities: The safest among long-term instruments are government securities (g-secs). The central government needs funds to run its day-to-day operations and finance the fiscal deficit. Apart from other avenues such as tax, it also borrows money from the debt markets, through the RBI, its banker, by issuing g-secs. State governments, too, borrow by issuing State Development loans (SDLs).
Since these instruments are backed by sovereign guarantee, they are the safest and most liquid. G-secs can come with maturities as long as 40 years. G-sec mutual fund schemes predominantly in these gilts. But other debt and hybrid funds, too, hold g-secs to manage their duration (interest rate sensitivity) and maintain a good credit mix.
Bonds and Debentures: Likewise, when companies need to borrow money for their long-term requirement, they issue bonds and debentures. These come with tenors of 1-15 years. But since corporate bonds do not come with a government guarantee (unlike g-secs and T-bills), they carry higher credit risk. To compensate, they also pay higher interest rates.
Therefore bonds also come with credit ratings. Unless, you invest in a credit risk fund, go for bonds that invest sizeably in highly-rated instruments. Typically, bonds issued by government-owned companies are considered safer than private-sector firms, but that is not always the case.
Note that short term debt funds too hold certain portion in G-Secs and bonds with short residual maturity of, say, less than a year.
Securitised debt: Securitized debt instruments are securities that are created by securitizing individual loans.
Simply put, a bank has a car loan portfolio worth Rs 1000 crore. To free up the capital, the bank creates debt instruments (which are called pass-through certificates or PTCs) backed by the asset, which is the car loan portfolio here, and sells to the mutual funds and others.
Technically, a securitization transaction involves sale of receivables by the originator (the bank) to a Special Purpose Vehicle (SPV), typically set up in the form of a trust. Investors (mutual funds) are issued rated PTCs, the proceeds of which are paid as consideration to the originator.
These securitized debt instruments are rated by the rating agencies. Mutual funds prefer holding only those rated AAA.
Risk of investing in securitized debt is similar to investing in debt securities. In January 2019, a few debt funds from Aditya Birla and HDFC mutual funds were hit as the SPVs of two road projects owned by IL&FS, which they held, defaulted on interest payment.
A few mutual fund schemes allocate 0.2-10 per cent of their portfolios to these instruments. As on August 31, 2020, MFs held Rs 9,685 crore in such securitized debt instruments.