Part 2 – Debt Mutual Funds Basics

This is the second article in a series of articles on simplifying debt mutual fund investors. The first part can be read at “Part 1 – Debt Mutual Funds Basics“.

Debt Mutual Funds Basics

I have already given you a basic understanding of when we actually have to look for debt mutual funds. In this post, I will explain to you certain advantages ONLY. We have to concentrate on DISADVANTAGES in a big way. Hence, I will cover each disadvantage in a single separate post.

Advantages of Debt Mutual Funds

# Liquidity – You can invest and withdraw at any point of time (subject to exit load and taxation). Hence, they offer greater liquidity for the investors.

# Diversification – Instead of holding a single bond, debt mutual funds usually hold a bunch of bonds of different maturities or of the same maturities based on the fund mandate. Hence, you are reducing the risk of exposing yourself to a single issuer.

# Taxation – Even though post 1st April 2023, the taxation of debt mutual funds is the same like your Bank FDs (taxed as per your tax slab), the advantages debt mutual fund offers are – no TDS and postponing your taxation up to your withdrawal. Because of these two features, I still suggest you debt mutual funds over Bank FDs (especially if your goals are more than three years or so).

I have written a detailed post on Debt Mutual Fund taxation at “Debt Mutual Funds Taxation from 1st April 2023“.

What do you mean by BOND?

As I have mentioned above, rather than directly jumping over to listing the disadvantages of debt mutual funds in a single post, I wish to cover each disadvantage in a single post. Hence, to move further, in this post, I will explain to you the concept of BONDS.

Understanding the concept of BONDS is very much important for all debt mutual fund investors as all of these debt mutual funds invest in bonds or FDs.

For a moment, forget about the word BOND. Let us discuss the Bank Fixed Deposits. We all know that banks need money to run their lending business. Hence, they offer fixed deposits of various tenures to investors. Accordingly, based on the suitability of the time horizon and interest rates, we all invest.

If the FD rate is around 7% for a tenure of 5 Yrs, then it is an obligation of a bank to give you interest of 7% on a yearly basis and at maturity return you back the principal you have invested.

What banks will do in return is they lend the money collected by you to the borrowers at say 7.5%. This 0.5% is a profit margin (including the expenses of managing borrowing and lending activity).

Have you ever noticed why different banks have different rates of interest either on FDs or on their lending rates? SBI Bank may offer you the least rate of FD. However, the local cooperative bank may be offering you the highest rate of FD.

It is all based on how much trustworthy the bank is and based on how much strong it’s financial situation is. If SBI gets the money from FD investors at 6.5%, then SBI bank’s lending rate is obliviously competitive for the borrowers.

For co-operative banks, as they are not safe like SBI Bank, to attract money from depositors, they offer higher FD rates. As for the cooperative bank, the cost of borrowing increased, they lend at a higher rate.

For the borrower of the cooperative bank, the cost of the loan is high. However, few borrowers may still approach cooperative banks as they may not get the loan from SBI due to their low credit rating.

Hence, in the case of SBI Bank, the depositors look for safety and hence sacrificed the returns. The bank by lending to high credit rating individuals (at lower prices), protects the depositor’s mood.

But in the case of cooperative banks, as depositors take risks, they are offered higher rates. Cooperative banks obviously have to lend money at a higher rate. Who will borrow at a high rate? Obviously, the one who not got a loan from SBI due to his low credit rating.

In simple words, SBI created safe deposit and loan portfolios of borrowing and lending. However, cooperative banks created risky deposit and loan portfolios of borrowing and lending.

Finally, now, replace your mindset from FD to Bond. Bonds also work in a similar way to Bank FDs. The only difference is that bonds trade (which I will explain to you in my next post). Bonds may be of various categories based on the issuer. They may be Central Government Bonds, State Government Bonds, PSU Bonds, Bank Bonds, Corporate Bonds and etc.

Let me give you an example. Similar to the bank FD example, if a company needs money to run its business, it has two options. One way is either to borrow from a bank or issue a bond.

Borrowing money from banks comes with a lot of restrictions like how the money is to be used and for what purpose. Hence, to avail of the freedom of usage, corporates borrow money through bonds.

Bond means like a Bank FD of various tenures. If a company is offering you a Bond of Rs.100, then its value is mentioned as face value. You the investors have to invest Rs.100 to buy this bond. On this bond, the company may say that we offer you 7% interest for the next 10 years. Such interest in the bond market is called a coupon. Ignore these technical terms of face value and coupon. For your simplicity, just assume that a bond is nothing a kind of FD issued by corporates, government, or PSUs. At maturity, you will get back the invested amount. Few bonds may offer you that they pay interest and principal at maturity and few may say they will pay interest on a yearly basis. It depends on the nature and features of the bond.

Now in the next post, I will explain to you what IF your bank FDs have an option to buy and sell in the secondary market like stocks. Understanding this feature of bonds is very much important for debt mutual fund investors. Hence, I will cover this in my next post.

I hope I have cleared the concept of bond basics.

Read the next part here – Part 3 – Debt Mutual Funds Basics

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