Debt funds

Most Indians who own bonds own them through a debt fund without having read a word of the previous seven chapters. This one connects them.

What a debt fund is

A mutual fund whose portfolio is bonds. Everything from the mutual funds subject applies — units, NAV, expense ratio, direct and regular plans — and everything from this subject applies to what it holds.

SEBI's description of an income scheme is accurate and slightly understated: such funds "generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments", are "less risky compared to equity schemes", and their NAVs "are affected because of change in interest rates in the country."

That last clause is chapters 3 and 6 arriving inside a fund. When rates rise the bonds are worth less, so the NAV falls. Nothing has malfunctioned.

The two dials

Every debt fund is a position on two dials, and between them they explain almost all of its behaviour.

Duration — how much interest rate risk. An overnight or liquid fund sits near zero and barely moves. A gilt or long duration fund can carry 7 or more and moves a lot. Chapter 6.

Credit — how much default risk. A gilt fund holds only government securities and takes none. A corporate bond fund holds mostly the highest rated paper. A credit risk fund deliberately holds lower rated paper for the extra yield. Chapter 7.

SEBI's categorisation, from chapter 5 of the mutual funds subject, is essentially a grid over those two dials, which is why the category name tells you more here than it does in equity. A "low duration fund" is a description of the first dial and a promise about it.

The useful consequence: a fund's name tells you which risks it is taking, and the factsheet tells you how much.

The three numbers to read

From the fortnightly portfolio that SEBI requires debt schemes to publish within five days of each fortnight:

Modified duration. Multiply by a plausible rate move and you have the downside. Chapter 6.

Yield to maturity of the portfolio. Roughly what the fund earns if nothing defaults and rates stay put — before its expense ratio. Chapter 5's discipline applies: this is a forward number, unlike the trailing return, and it is the better one to compare funds on.

The rating breakdown. How much is sovereign, how much AAA, how much below. This is where an unusual YTM gets explained. A fund yielding noticeably more than its peers is doing it with duration or with credit, and these three numbers say which.

The mistake that has cost Indians the most money

Treating a debt fund as a better fixed deposit.

The sentence is always some version of: it's debt, so it's safe, and it pays more than the bank. Both halves fail.

A deposit has no market price. Nothing marks it down when rates rise, and the bank owes you a fixed sum. A debt fund owns bonds that are repriced daily — by chapter 3's arithmetic when rates move, and by chapter 7's when an issuer is downgraded. The NAV can fall, and in a credit event it can fall abruptly and stay down.

And remember what SEBI says a rating excludes: "liquidity risk, pre-payment risk, interest rate risk, risk of secondary market loss". A portfolio of highly rated bonds is protected against exactly one of the things that can hurt it.

The funds that genuinely resemble a deposit are the ones holding very short, very high quality paper — low duration by construction, little credit, and correspondingly little extra yield. That is the trade, and it is an honest one as long as nobody pretends the extra yield came from nowhere.

When a fund beats buying directly

Chapter 4 set up the comparison. Resolving it:

A fund is better for corporate credit. Buying three corporate bonds is not diversification, and chapter 7 says one default removes years of extra yield. A fund holding dozens of issuers is a genuinely different risk.

A fund is better when you do not know your horizon. Daily liquidity, and someone managing maturity as bonds roll off.

Direct is better for government securities with a known horizon. Retail Direct is free, the credit question does not arise, and matching maturity to need neutralises chapter 3 entirely. Paying an annual expense ratio to hold government bonds you could hold yourself for nothing is hard to justify over a long period — chapter 10 of the mutual funds subject is the arithmetic.

Costs matter more here

One thing the mutual funds subject said deserves restating in this context.

Equity funds charge 1–2% against an asset class that might return 12%. A debt fund charging 1% against a portfolio yielding 7% is taking about a seventh of the return. The expense ratio is a far larger share of a smaller number, and the direct plan gap of chapter 10 of the mutual funds subject is correspondingly more decisive.

The point

A debt fund is a position on two dials — duration and credit — and its factsheet publishes both every fortnight. It is not a deposit: it holds bonds that are repriced daily, and a rating covers only one of the ways they can fall. Costs are a bigger share of a smaller return, so the plan you buy matters more here than anywhere.