Understanding Bonds and Debt Funds

Hi, I'm Monica Hallon and this is my podcast Let's Talk Money. Every Friday a new episode will drop that gives you a snapshot analysis of one money-related topic that has meaning in your life. And then I answer your money questions. My hope is to put you on the path to financial stability and freedom. So let's talk money. A little bit of a heads up. In the next few weeks, I may be a little erratic. There is an overseas trip looming ahead and I will try and record in advance but if I don't please forgive me, I know that you look out for the podcast but I may skip maybe one in the middle. Today I actually want to talk about something which most people don't understand which is bonds and debt funds. Most people think that mutual funds is just equity but it is not. They also invest in bonds and the minute I say the word bond, people are not really certain what it means. So let me first talk about what is a bond. So imagine you need say 10 lakh. You can borrow this from a bank or you can borrow directly from anybody in the public by issuing what is called a bond. It's like an IOU. You the borrower promise to pay regular interest called a coupon and the principle the amount that you invested is returned at the end which is called a maturity. So this is just jargon but it's really like a bank FD except that instead of a bank you are giving it to a company and this becomes a tradeable financial instrument once it gets listed on a market. So a bond is really a fixed interest instrument which is tradeable mostly where it is listed. Who issues bonds? A lot of people, governments issue bond they're called G-Sex, G-RITS, companies issue, they're called corporate bonds, banks issue, they're called bank bonds, municipalities issue so like everybody can issue a bond. Anybody who's a firm can issue a bond. So let's say that every bond has a face value of 1000 and on this 1000 you let's say you get 8% interest a year and this bond matures over 5 years. So you get 80 rupees every year and at the end of 5 years you get your 80 rupees plus the 1000 that you invested. Okay that's it except that if this bond were to be sold right then the price of the bond comes in at that stage and that's where what whole makes this whole debt market so complicated because you know what when interest rates go up bond prices go down and that's because people want to buy bonds with a higher interest rate and the reverse happens when interest rates go down. So the minute you are listing and there is a second remarket on bonds these rules come into play. So typically what we know is that government bonds are the safest PSU bonds are next corporate bonds are higher risk and their bonds are of all maturity short term medium term long term and how do you know that the company is credit worthy. So you have rating agencies who give them a credit rating to say how safe is your money for interest in principle. So triple A is like the highest quality double A triple B is investment grade Bb and below is junk or high yield so the lower the credit rating the higher interest the company has to offer to attract money okay. Now there are two ways to make money from bonds you can get the interest income it's called the coupon which is the regular interest payment it's predictable it's steady then there's capital gains on bonds if you sell the bond before maturity at a higher price than you bought it that's where the capital gain comes in. So this bonds now when you make clusters of these bonds you get what is called a debt mutual fund. So you're owned by five individual bonds you buy a debt fund which is like a pool of money managed by a professional that buys this basket of bonds but then when the fund managers choosing this basket he tries to make the bonds similar in many ways okay which means that he'll try and put the majorities the similar majorities of the bond in one bucket. So what you get is diversification across many bonds you get professional management you get liquid it you can sell your debt fund you get to go money next day. So typically what happens is so what Sebi has done is it's classified the bonds the debt funds into I think there's 16 categories right now so different categories and each category has a meaning so before you invest in a debt fund you have to match your holding period with the maturity of the bonds in what time will the bonds in this bucket mature those should match for example a liquid fund will hold very short term bonds 91 less than 91 days so the average maturity of all the bonds in that bucket will be less than 91 days then there'll be ultra short duration 3 to 6 month period short duration 1 to 3 year bonds. Guild fund will only be government bonds so you will have a debt fund type to suit your specific need so you have to remember that you have many risks in a debt fund there's an interest rate risk if the interest rates rise your funds NAV will fall and the longer duration funds are more exposed to risk simply because there's more time and it's unpredictable what will happen then there's a credit risk which means that we don't know what happens to the business of the firm who's borrowing the money if the business is under stress then the company may not pay the money right so the credit rating of this company will fall so what you need to really remember in a debt fund is you have to be careful there are very safe parts of the debt market which are actually good for investors who may not understand the risks of debt there are higher return options like a credit risk fund even guilds can be very risky if you invest in them at the wrong time so it's really safer for debt fund investors who may not know all the risks to stay with looking at a riskometer which every fund has to publish and update every month and go for the low low to medium risk debt funds so just wrapping this up bonds are loans that you give to governments to companies and what you're looking for is regular interest and the surety of your principle coming back when these get listed there's a price which emerges and the bond market reprices them based on interest rate expectations and other macro conditions debt funds allow you to participate in this market for small amounts of money getting professional fund management but they are not risk-free like fixed deposits you need to understand them before you on board and now i'll move to questions i have Ajay Sojitra from Surat who says i've been your follower for the last two three years i don't remember when i came across your book let's talk money but certainly it has significantly influenced my thinking about personal finance and its importance thank you for writing the next part let's talk which we'll fund and let's talk legacy both are very essential next steps your podcast is like the icing on the cake for tackling real life situations thank you so much Ajay i am 29 years old i'm working for this company for the last seven years so look i will actually hide some information if i'm using your name okay just for privacy issues and you write i married have a one-year-old daughter my wife is currently a housewife but learning digital marketing my parents live in surat my mother is a housewife and my father has his own small textile business and is not dependent on me as of now my job is transferables up to keep moving three to five years i have a home and a car loan from my company which is a low interest loan without compounding and the loan is waived in case of death nice company yoke for her i have my own house and my name in surat where my parents live i'm the only son i have two sisters both married my family including my parents are medically covered by the company not by separate insurance but the medical fund of the company i get around this much for my hand after emi home loan and home and car loans i've built my emergency fund which is adequate according to me when i see the number in the mix of money market and psu banking sector fund i have enough term insurance i have started investing in nifty 50 regularly my plan is to increase this amount by 10% every year my monthly expenses are less than half of my take home my current portfolio is pf and ps largely in debt my assets are heavy in debt and i see Ajay that your debt equity allocation is 76, 24 in favor of debt. Based on the above, so there's more information. So I am planning to be financially independent by the age of 45 and by that time my home loan rebalance the repayment will still be around 22 lakh. But if I resign from my job, I will lose my medical cover. I am also planning to have three kids. So Ajay at 29 you're actually more sorted than most people in their 40s and 50s. So congratulations for that. This is very good planning. You've begun early you actually have a 30 year runway of earning saving investing. Even if you do want to retire at 45 and I'm actually you know I'm sure you will not stop working fully even if you are financially independent because honestly 45 is too early to just sit at home. I hope you'll think about this because kids grow up and go away, have their own lives and work actually gives us a lot of meaning in life and sometimes it also earns you good money. I'm going to point out a few things in your portfolio. One, you definitely need your own medical cover. Buy a family photo because once the other kids that you're planning to have come around and you will definitely need a family photo which you have to include every new kid as they come along. Second, looking at your portfolio, you're a conservative spender. You're managing to save more than half of your take home. But your debt allocation is too high for someone your age. With so much in low return debt, you will not get the boost of equity long term. At age 29, you should be 70% in equity and not the other way round because you know what, your seat belts on on emergency, life insurance medical, I'm sure you will buy now. Your wife is planning to begin earning through digital marketing. I think you should use a planned approach to switch far more money into equity than you're doing right now and please stay with the safer part of the equity market like what you have said you've done. It looks like a prudent person's portfolio but I would just tweak the asset allocation because you know what I did the numbers for you. You said extra 10% savings per year and I've just extrapolated your spending using inflation for the age 45. I'm not seeing the money for you to retire at 45. So you will have to I think just work longer and target a higher rate of return because even at a you know what FD's give you 7, 7 and a half 8 if you blend a little bit of equity into that. So at 78% you're not going to get that. But on the whole you're on track is just a little tweak which is required. Ananda Bhattacharya and Kolkata says I am 45 years old government servant living in Kolkata. Carefully studying your book let's talk mutual fund. I love this Ananda. Carefully studying your book. It's like a textbook I know. What is the meaning of accloy in duration? I would be grateful if you would tell me. I call it sorry I always get that wrong. So look I've explained debt funds in this and this question comes at a good time. When we buy debt funds we need to match our holding period to that of the bond basket. Okay. So if you want the money in three months and there's a bond which is maturing in 20 years it's a mismatch isn't it? If you want the money in three months the bonds should be maturing in three months as well isn't it? One way to measure this is called a my college duration. It's a measure of the weighted average. It's basically in time in years that how much time it takes to receive all the cash flows from a bond or a bond fund. Okay so it gets technical it's weighted by the present value but let's not go there. So this was developed by an economist McColley in 1938 and it is widely used in debt funds. I know that Sebi uses it in the debt fund debt classification. So let's say a bond is paying coupons. I said coupons is really the interest. It pays it annually for five years and returns to principle. If most of the value of the bond will naturally come from the final repayment right because you get a hundred back then and five rupees if interest is five. The my college duration might be 4.2 years because most of the money is coming at the end of the period because it's so this 4.2 means that on an average you will recover your money in 4.2 years. That's just what it means and how do we use it a higher my college duration means greater interest rate risk but also a greater potential if rates fall. Okay so there is higher risk for higher my college duration but there's a potential for again if the interest rates fall. It is actually a very important metric to check. See what Sebi then has done is baked all of this into the riskometer because I think the ask of the investors is too much to say you should know my college duration be I should know this also you should know that also it's not possible. So Sebi has baked all these things into the riskometer so please look at that. There is Ragavindra Sudhakaran who says your book on mutual funds was one of the best books I read when I started my SIP journey. It helped us decide on mutual fund portfolio from scratch. My wife and I both work know that obligations currently we have an eight year old daughter. We are from humble background with no inheritable assets. So all our savings and investments are towards our financial stability. Recently I have been hearing a lot about international funds targeting US China Taiwan. Sometimes I feel it's a bit organized but unable to discount it completely. How might I think about it with my background. So look Ragavindra's funds are best look as a slice of your asset allocation by not the whole thing just a slice and you do it only if your domestic asset allocation is in place before you look outside and even then it is safest to go through mutual fund rather than trying to do it by yourself because look people will keep saying oh the US market is up so much oh the Taiwan market is up. It's all last month's return okay it's not prospective it's retrospective so it's like chasing a rainbow. The only thing you have in control is your asset allocation. I would keep no more than 5 to 10% of my portfolio in international funds honestly and that too when I have a very solid domestic portfolio. The question is where do you put this 5 to 10% look US as a capitalist economy. It's tended to keep reinventing itself it constantly regenerates who it is. A slice of that by maybe good for overall diversification but do not get pushed into the decision by influencers. Who are basically making you jump from idea to idea be go and now silver now foreign it's very exhausting so it's better to say okay I will give up on the return and you know a lot of people talk about how the rupee has fallen in value versus the dollar yeah sure but unless you know you're earning in rupees you're spending in rupees where is the problem it's only if you are taking the money out that you face to loss isn't it so I would really discount a lot of the messaging which comes across which makes you feel guilty left behind I think just build a solid domestic portfolio once you are of a certain network you and have the bandwidth diversify into international if you don't it's okay there is enough money to be made in the domestic market without worrying about going abroad. It is important for a person of a high network a very high network who will need this diversification but as entry level retail investors please don't get pushed into this focus on the core and just follow the rules. And that's a wrap for today I enjoy answering your money questions remember I don't look at individual portfolios I don't recommend products look upon the space as a place to ask strategy questions doubts and just basic things that you might not understand each time you have a good money outcome I feel that I have won to make sure that you don't miss an episode press follow and help your friends get money smart by sharing a link with them you can reach out to me at mail me at theratemonicahulland.com that's Monica with the K tag my social media handles at the rate Monica Helen and finally remember that you should have money and money should not have you so let's talk money again soon bye