A debt fund invests in various instruments – namely, government securities, bank certificate of deposits (CD), commercial paper (CP) issued by corporates and debentures/bonds. While all these instruments may differ in some aspects, there is one thing in common among all debt instruments – they all carry interest.

This interest rate is pre-decided at the time of investment and the interest component will not change during the course of the debt outstanding. The maturity value of debt instruments is also known at the time of the investment and the investor can be certain to receive this sum as a repayment of the principal invested. This is why the terminology “Fixed Income” is used for this asset class.

* Unlike in equity where returns are largely dependent on price movement of the underlying shares, returns from fixed income are significantly attributable to the yield of the portfolio. There can be fluctuation in portfolio value during the course of the investment but they will yield a pre-determined return if held till maturity. This makes them a great investment for predictable and regular income as well as providing stability to a portfolio when other asset classes underperform.

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* Inclusion of fixed income reduces the volatility of the portfolio as well as adds an income component to the portfolio. It is for this reason that fixed income as an asset class appeals to pension funds. As an example of the prevalence of fixed-income securities in pension portfolios, the largest pension plan in the U.S., the California Public Employees’ Retirement System (“CalPERS”)has one-third of its $385.1 billion portfolio allocated to fixed-income investments as of March 2020. For some pension funds, this allocation is as high as 50%.

* Debt instruments are similar to Fixed Deposits but with the additional advantage of regular cash flows unlike an FD where cash flows are received only at maturity. In addition, mutual funds offer liquidity without any penal charges in most cases unlike in FDs where pre-maturity attracts penal charges. Mutual fund schemes hold sufficient liquid instruments which can be easily sold to meet redemptions.

* For mutual funds, the interest accrued is added on a daily basis to the NAV. So the closing NAV on an given day will include the accrued interest till such day regardless of the timing of actual interest receipt.

* Investors can choose from schemes with various maturity buckets with as low as 1 day to several years and choose one of the multiple ways to get regular withdrawals from the investment.

* Investors can choose from various schemes to suit their credit risk appetite and can also choose gilt funds (investments in only government securities) to eliminate credit risk.

* A Systematic Withdrawal Plan (SWP) is one such mechanism that allows the investor to withdraw a set amount of money from their mutual fund investment at regular intervals (monthly, quarterly, etc.)

* A benefit with debt funds is regular cash flows in the form of income. So, if a sizeable corpus is built over time and the investor desires a regular income stream post-retirement, a part of interest earned from these funds can be used to fund the withdrawal. This helps conserve capital to the extent that coupons earned from underlying securities can fund withdrawals from the fund

* It is always better if you start early so that the cash flows are sufficient to cover the required expenditure and maintain a desired standard of life. Starting early also helps reap the benefit of compounding

(By Abhishek Sonthalia, Fund Manager – Credit Strategies, Tata Asset Management)