Debt funds demystified! Know which fund suits you the best

Managing Debt Funds is certainly not as glamorous as equity mutual funds, but still they perform an important job for investors in the following areas such as

1) Principal Protection - As a majority of the debt  funds  are  rated  for  credit quality by an external rating agency

2) Tax free returns -  In the hand of the investors and lower tax outgo when compared to other fixed income instruments like FD’s   etc.

3) Low Risk -  When compared to equity as most of the debt funds invest only in the highest credit rated debt paper.

Debt Funds can be broadly classified in two types. Long term and Short term funds. Within these broad categories, there are open and close ended funds. Open Ended funds are the Long term Income Funds, Short Term debt funds, Liquid Funds and Ultra Short Term Funds.  Under the close ended fund category one can find fixed maturity plans and capital protection funds. Fixed Maturity Plans can be both short term and long term too. You can find a FMP as short as 15 days and as long as 5 years too.

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Ganti Murthy

Head of Fixed Income|IDBI Mutual Fund

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In debt markets and debt funds, the risk increases with a corresponding increase in maturity. The longer the maturity  of  either  the  security and  fund, the  greater the  risk  of  valuation loss  as  longer maturity  securities  lose more in value  when  interest  rate  rises (the  relation between yield and  price  is  inverse , when yields  rise , prices fall and  vice versa).  In such a situation how does an investor make a distinction between long term and short term funds and how does one invest.

In debt  funds,  investors  can make good  returns  if  they can  time  the movement of  interest  rates properly. Investors then can make sizable capital appreciation along with current income. In case  investors  are  looking for  current  income and  principal  protection , then  short  term  funds  offer the  least  risk.

But  then comes  the  main question , how  does  one make  a choice  between  various debt funds.  Every Investor needs to look at 3 major points before making a decision to invest , namely ,

1) What is my time horizon?

2) What is my risk appetite?

3) What is my investment objective?

What is my  time horizon:-  If the  investor has  a short term time  horizon, then a short term FMP or a money market fund ( liquid fund) would be ideal  as the capital would be  protected and the investor can enjoy current income without being bothered with the  vagaries of the daily fluctuations of the bond market.  If an investor  has a longer time horizon of  a year and more, with a higher  risk  appetite to ride out the  vagaries of the bond market  over a longer time  period, then a long term fund  like a income  fund or a gilt fund would be ideal.

What is my risk appetite? :-  If  you have a conservative risk appetite and abjure excessive  risks, seek capital protection and  steady income, then a short term  fund  would be  suitable. Funds under this category would be money market funds, ultra short term and short term bond funds which invest in short maturity corporate bonds.  On the other hand, an investor who seeks long term capital growth thru strategic movement in interest rates and bond yields should aggressively invest in long term bond and gilt funds.

What is my investment objective: - What is the core purpose for which an investor seeks to invest in either long term or short term funds. What is the investment objective? Is the investor seeking principal protection before taking a view on markets? Or the investor wants aggressive growth answering these questions would determine the path the investor would take while choosing long or short term debt funds.

So in conclusion, the decision to invest either in short term or long term depends on the various factors listed above. Investors would do themselves a great service if they list out their preferences and objectives and then make an informed decision before investing their hard earned money.

The author is the Head of Fixed Income, Peerless Funds Management Company Limited