Understanding the ABC of Debt funds

Most of us consider debt mutual funds to be the poorer brethren of the equity mutual funds which garner most of the attention. A debt mutual fund scheme invests in debt papers like Government bonds, fixed deposits, approved private deposits and so on. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. It is important to hold the right mix of Debt - Equity in the portfolio that will help you optimize returns while managing returns.

As a first step, we need to understand the basic difference between bonds and debt mutual funds because often they are erroneously perceived to be the same.

• It is less risky to invest into a debt fund than to invest directly into a debt security
• The investor of a bond or debt security gets the interest or the coupons directly, whereas an investor in a debt fund receives a dividend at the discretion of the fund house
• There can be times when you may not be able to sell a debt security in the debt market, or you may be able to sell only at a huge loss as there may not be anyone willing to buy. With debt funds, the fund house will always redeem your fund units at the declared NAV
• Debt funds are managed by professional fund managers whose job is to track and invest in the debt market. As an individual bond investor, one may not have the time and resources to track and invest appropriately
• Bonds or debt securities have a maturity date but the debt funds do not have a maturity date

Classification based on underlying instruments -

The classification incase of debt mutual funds is typically based on the underlying instruments, the most commonly used mutual funds within this category are -

Liquid Funds / Liquid Plus Funds or Money Market Funds

'Liquid', here means anything that is almost as good as cash. Money market funds or Liquid funds as they are commonly known, are one of the safest places to park your money for short periods of time. The funds invest into money market securities and debt securities that mature in 91 days.
Most Corporates park their short term money into these funds. There is a subtle difference between Liquid / Liquid plus funds; as they say the devil is in the details and in this case the tax aspect is the key differentiator. The liquid plus funds attract a 14.1625% while plain liquid funds dividends are taxed at 28.325%.
Some of the benefits of parking money into liquid funds are -

• Zero exit loads
• Investments are very safe
• Money can be redeemed in a day
• Lowest expense ratio of all the mutual funds
• One can invest with a minimum of Rs 5,000
• Multiple periods of dividend reinvestment options - daily, weekly, fortnightly, monthly

Floating Rate Funds

Floating rate funds or Floaters invest into floating rate debt securities. Most of the debt securities in a floater fund will mature within a year. The main benefit of investing into a floater fund is that when the RBI increases the interest rates, the interest rates on floating rate debt securities also increase, thus when interest rates are expected to rise, floaters are better debt investments than other debt funds.

Floating rate funds invest 65% to 100% of their money into floating rate instruments and the rest in other debt securities.

Gilt Funds

They invest their corpus in securities issued by the government. These funds carry zero default risk but are associated with interest rate risk. So, there could be a possibility that the debt funds lose some part of their net asset value (NAV) also. But these schemes are safer as they invest in papers backed by the government.

Income Funds

A type of mutual fund which emphasizes on current income, either  on a monthly or quarterly basis, as opposed to capital appreciation. Such funds hold a variety of government, municipal and corporate debt obligations, preferred stock, money market instruments, and dividend-paying stocks. These have a tendency of moving in the opposite direction as compared to Interest rates. Hence it would be a good option to avail when the interest rates have peaked and are likely to turnaround.

Fixed Maturity Plans

FMP is a closed-ended fund that invests in debt and money market instruments of the same maturity as the stated maturity of the plan. The focus of a fixed maturity plan is to provide a stream of income through interest payments, while exposing the investor to a lower level of risk.

Monthly Income Plans (MIP)

They invest most of their corpus in debt instruments and a minimum in equities. They get the benefits of both equity and debt market. These schemes rank slightly high on the risk-return matrix. These try to give you a monthly income in the form of dividends, which is of course not guaranteed. These funds are for investors, who have a big corpus initially, and would like to generate a monthly income for themselves with low to moderate risk.

And finally, here is a quick reckoner on debt mutual funds -

 

Fund Type	Invt. Objective	Liquidity	Risk	Returns	Loads	Invests in
Liquid / Liquid Plus Fund	High level of income from short term investments	Very High - within 24 hrs	Very Low	4.5% - 5.5%	Entry / Exit - Nil	Call Money, T Bill etc..
Floating Rate Fund	Provide income consistent with the prudent risk ( LT & ST available)	Very High - within 24 hrs	Very Low	5.35% - 5.6%	For ST - Nil; For LT - Exit Load - 0.25% - 0.5% ( for invt. Upto 3-6 mths)	Mibor linked papers
Incoem Funds	Generate both income & capital appreaciation	3 Business days	Credit / Interest Rate Risk	6.5% - 7.75%	Entry / Exit - Nil / 0.25% ( 15 days - 6 mths)	G-secs, corpporate, cal money, bank deposits
Fixed Maturity Plans	Tax efficient yeild as compared to Bank Deposits - has locking	2 Business days	Credit / Interest Rate Risk	7.5% - 9%	Lockin	Bank Deposit, G-secs
Monthly Income Option	Generate regular income & Capital Appreciation	3 Business days	Moderate Risk	8% -12%	Entry / Exit -0-1% / 0.5% (6 mths)	Short duration fixed income paper, equity funds

 

Hope this helps you in choosing the right debt mutual fund to complement and balance your portfolio.

- Anil Rego

The author is CEO & Founder of Right Horizons. He can be reached at anilrego@righthorizons.com