Nov 05, 2012 11:16 AM IST | Source:

How does Long Term Debt Funds work?

Debt mutual funds are neglected by investors often due to lack of understanding of these products. However, this category of schemes provides ample opportunities to earn handsome returns in the fixed income space. Read this space to understand the various categories of debt mutual fund and know the benefits from investing in them.

Long term debt mutual funds do not find much favor with small investors. One of the reasons is that they find it difficult to understand the market and not many advisors recommend it. Although fixed maturity plans, monthly income plans and liquid funds have been attractive in different scenarios, long term debt funds are still left out. However, this category of schemes provides good opportunities for investors who want to benefit from interest rates movement and have long term goals to meet.

Let's understand how these funds works and why you should invest in them-

Income Funds: These funds invest majorly in corporate bonds, debentures and government securities. Exposure to treasury bills, call money market, securitized debt etc. is also taken to diversify the portfolio.  To ensure high liquidity and mitigate the risk, the fund manager invests majorly in highly rated securities. Any scheme which desires to enhance the returns may take some amount of exposure in lower rated bonds. The objective of income funds is to generate regular income through the coupon payment received majorly from corporate bonds. But there are capital gains also as most of the securities are traded for a price. The movements of interest rates impact the coupon payment and prices of securities. In an increasing interest rate scenario the coupon payment from bonds increases but the prices of government securities fall. Conversely, when interest rates falls the prices of securities appreciates but the coupon payment takes a downward trend. An income fund tries to do a balancing act by taking exposure proportionately. Thus, when interest rates are at peak the opportunity in these funds would be high as coupon payments are high and with fall in rates prices of securities generates higher returns for the funds.

Gilt Funds: As the name suggest, these funds invest in government securities of longer maturities. Since G-Secs have the highest impact when interest rates rise or fall, the gilt funds are the most volatile among debt funds category. The trading price of government securities behaves inversely to interest rates. When interest rates are rising the existing securities will trade at a discount due to availability of new securities with higher coupon. So the return generated from these funds is lower during this period, sometimes in negative territory if the rise is very steep. Conversely, when interest rates falls, the prices of securities appreciates and gilt funds generates higher returns. Since there are periods of interest rates moving either side, it makes these funds volatile. But this also brings opportunity for investors as this category has ability to generate higher returns when interest rate finally takes a downward trend. Within gilt funds some also takes good exposure in collateralized lending and borrowing (CBLO) and other money market instruments which create a difference in the returns between various funds. Investors who have a slightly higher risk appetite and a 2-3 years horizon will find it an attractive proposition to invest in gilt funds.

Which one to Choose?

This more or less depends on one's risk appetite. Income funds are less volatile then gilt funds and so investors who are not comfortable with heavy fluctuations in their portfolio will find this category more appropriate. Also, as discussed above, income funds provide best opportunity when interest rates have peaked. For layman investors it's difficult to predict the rates movement. But by keeping a fairly longer horizon and investing systematically one can reap the benefits from these funds.

Time Horizon

Generally, you should have a horizon of at least 2-3 years to earn maximum out of these funds. However, gilt funds have been a good option even for meeting long term objectives. The returns from some of the good funds have been in the range of 9-10% for more than 10 years investment which yield higher returns post tax then other comparable instruments. Thus, these funds can be considered for debt exposure in your asset allocation strategies for long term goals.

How to Invest?

You can invest either as a lump-sum or through regular contributions. For small investors SIP is the most viable option. If you have a lump-sum to allocate, investment through Systematic Transfer Funds can also be avail.

Long term debt mutual funds are a good choice considering the indexation benefit. A little awareness and right manner of investment can help in availing maximum benefit from these two categories.

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