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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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
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