Do you know how to select debt funds: types of Debt funds

In the last blog post - Do you know how to select Debt funds: Understanding the risk - we discussed various types of risks that may be associated with investing in debt funds. We also discussed how the debt funds are much more predictable than equity funds and understanding the risk of debt funds vis-a-vis equity funds.

In this post we will understand the various types of debt funds and how these can be ideal for your different investment needs.

Different Types of Debt Funds

We will now discuss different types and how they address different investment needs.

Gilt Funds:

Gilt funds invest in Government securities with varying maturities. Since these funds invest in Government securities there is no credit risk. However, they can be susceptible to interest rate risks, depending on their average durations. Gilt funds can be either short term or long term. Short term gilt funds are much less volatile than long term gilt funds, in different interest rate scenarios. However, over a long investment horizon, say 5 years or more, long term gilt funds can give higher returns.

Income Funds:

Income funds invest in a variety of fixed income securities such as bonds, debentures and government securities, across different maturity profiles.Their investment strategy is a mix of both hold to maturity (accrual income, low interest rate risk) and duration calls (high interest rate risk). These funds are suitable for investors who have a long investment horizon, appetite for volatility and need for income during the investment tenure. Investors should have a 2 to 3 years or more investment horizon for income funds.

Short Term Debt Funds:

Short term bond funds invest in Commercial Papers (CP), Certificate of Deposits (CD) and short maturity bonds. The average maturities of the securities in the portfolio of short term bond funds are in the range of 1 – 3 years. The fund managers employ a predominantly accrual (hold to maturity) strategy for these funds. Since average maturity is low (low duration) interest rate risk is limited. This fund is suitable for investors with low risk appetite and short investment tenures (e.g. 1 to 2 years). Investors with long investment tenures, expecting a certain degree of stability in income can also invest in short term debt funds. However, such investors should have a reasonable income expectation because the yields (and consequently, fund returns) will fall when interest rate falls.

Credit Opportunities Funds:

Credit opportunities fund, also known as corporate bond funds, are similar to short term debt funds. The fund managers lock in a few percentage points of additional yield by investing in slightly lower rated corporate bonds. However, when investing in these funds, you should be mindful of the risks associated with sudden ratings downgrade. These funds are suitable for a two year or so investment tenure.

Fixed Maturity Plans:

Fixed Maturity Plans (FMPs) are close ended schemes. In other words investors can subscribe to this scheme only during the offer period. The tenure of the scheme is fixed. FMPs invest in fixed income securities of maturities matching with the tenure of the scheme. For example, if the tenure of an FMP is 1100 days, then the fund manager will invest in bonds which will mature in 3 years and hold them to maturity. This is done to reduce or prevent re-investment risk. Since the bonds in the FMP portfolio are held till maturity, there is no interest rate risk. The returns of FMPs are very stable.Since these funds have fixed tenures of three years or more, investors stand to gain from long term capital gains tax advantage of debt funds. Long term capital gains of debt funds are taxed at 20% with indexation.

Money Market Mutual Funds:

These funds invest primarily in money market instruments like treasury bills, certificate of deposits and commercial papers and term deposits, with the objective of providing investors an opportunity to earn returns, without compromising on the liquidity of the investment. There are two types of money market mutual funds – liquid funds and ultra short term debt funds. Liquid funds invest in money market securities that have a residual maturity of less than or equal to 91 days. These funds give higher returns than savings bank and are suitable for investment tenures ranging from a few days or weeks or months. There is no exit load. Withdrawals from liquid funds are processed within 24 hours on business days. Ultra-short term debt funds invest in money market securities with residual maturities ranging from 3 months to a year. These funds can give higher returns than liquid funds. These funds are suitable for investment tenures ranging from 3 to 12 months.

Conclusion

In this series of two posts, we tried to demystify debt funds with the objective of making you a smarter debt fund investor. Once you have a clear grasp of how these funds work, you will not find debt funds too abstruse and complex to match with your own various investment objectives. In this blog post, we have discussed how different types of debt funds can be suitable for your investment needs. In the next post, we will discuss some useful analytical concepts of debt funds, which will hopefully make you a better debt fund investor.