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A debt mutual fund invests an investor’s money in fixed income instruments like government securities, corporate bonds, debentures, and other money market instruments that provide capital appreciation. They are suitable for investors who are risk-averse and require a regular income. The debt funds have high liquidity, low-cost structure and are relatively safe. They are a better option as compared to bank fixed deposits as they are tax efficient and provide better returns.
There are different categories of debt mutual funds and they can be categorized on the type of securities in which they invest. It could be either the issuer which can be the government, corporate, and the PSU, or the tenor which could be for the short term or the long term. The risk and return will depend on the issuer or the tenor.
I) Categorization of debt mutual funds on the basis of issuer-
Gilt Funds-
Gilt funds invest in bonds and treasury bills issued by the central and state governments which don’t have credit risk. Since there is a very low risk of default due to being associated with the government the interest rate is low. The liquidity is good and the investment is made in instruments having various maturity periods. Long-term gilt funds invest in government securities of medium and longer tenure but are sensitive to interest change over a longer period.
Corporate bond funds-
Corporate bond funds invest at least 80% of their assets in debt securities issued by corporates and this can include the PSUs also. The investment is in AA+ and above-rated corporate bonds or non-convertible debentures. There is a certain credit risk associated with them so they pay a higher rate of interest. The price of the corporate bonds is subject to interest rate changes depending on the tenor of the securities held.
II) Categorization of debt mutual funds on the basis of tenor-
Liquid Schemes-
Liquid mutual fund schemes invest in fixed instruments like treasury bills, commercial paper, and government securities with a maturity of up to 91 days. The objective of a liquid fund is to provide liquidity and capital protection to investors. The fund manager tries to ensure that the average maturity of the portfolio is not more than 91 days. The securities in the portfolio above 60 days have to be marked to market which increases the volatility. So the fund managers prefer to keep securities below 60 days. Liquid funds can deliver better returns than a savings bank account.
Short term debt schemes-
The short-term debt schemes invest in securities of short duration where there is low-interest rate risk so as not to affect the values of the securities. The funds in this category are ultra-short term debt funds, short term debt funds, and short term gilt funds.
Ultra short term debt fund-
The ultra-short-term debt funds invest in debt and money market instruments with Macaulay duration of the portfolio between 3-6 months. The fund has a longer duration than the liquid funds but a shorter duration than other debt funds. Investors with a 3-6 month investment horizon can invest in these funds through which they wish to meet certain financial goals.
Short term debt funds-
The short-term debt schemes have an allocation to short-term debt securities with a small allocation to long-term debt securities. An investor with an investment horizon spanning from one to three years can invest in the schemes. The returns are stable with moderate risk. Fund managers decide to take exposure to the long-term securities depending on their view on the interest rate movement. In case they expect the interest rate to go down they increase their exposure to long-term securities so as to benefit from the increase in price. Short-term debt funds can be compared to fixed deposits having similar tenures but it is more tax-efficient than fixed deposits.
Medium duration debt funds-
Medium duration debt funds invest in securities with the Macaulay duration of portfolio between 3-4 years. The primary objective is to provide steady returns throughout the period. These funds have securities that have higher maturity than short-term funds but are lesser than that of long-term schemes.
Long term debt funds-
Long-term debt funds have a maturity period beyond five years. They invest in longer-term securities issued by the government and the corporate sector. There is greater volatility in the returns in these funds as the returns are impacted by the change in the value of securities in this duration. The longer the tenure of the fund the larger is the impact of the interest rate change on the portfolio.
These funds are suitable when the interest rate in the economy is expected to come down and they are also tax efficient due to the indexation benefit that can be applied if a person stays invested for more than 3 years.
III) Categorization of debt mutual funds based on Investment Strategy-
Income Funds –
The focus of the income funds is to generate regular income for the investors by investing in corporate bonds, debentures, government securities, certificates of deposits, and money market instruments. These funds try to deliver returns both in the rising and falling interest rate period. The corporate bonds deliver higher returns due to the credit risk they carry and the government securities are there to meet liquidity requirements and get capital gains that can be accrued from the interest rate movement. The income funds deliver higher returns than the bank fixed deposits. They don’t have lock-in like the bank deposits. These are suitable for persons who wish to have a stable income like a retired person.
Junk Bonds-
A bond is a promise to pay the investors’ interest along with the principal amount in return for the purchase of the bond. The investors buy bonds and in the process loan money to the issuer who promises to pay back on the maturity date. They get back the principal amount on maturity and also earn an annual interest rate during the life of the bond.
Junk bonds differ from regular bonds due to the issuers’ poor credit rating. They are issued by companies that have a high risk of default. Junk bond schemes operate on the thinking that the losses arising from the defaulting companies would be made up from the attractive returns offered by the other companies.
Dynamic bond Funds-
The dynamic bond funds invest in debt and money market instruments like government securities, corporate bonds of different time durations. Their criteria are not the long or short-term securities or any particular category but to earn income and capital gains from across the segments of the debt market. The fund managers invest across the market depending on their outlook on the interest rate. If the fund manager expects the interest rates to fall he will invest in longer-term bonds to earn profits from price appreciation and if he expects the interest rates to rise he would invest in short-term bonds to reduce interest rate risk. The dynamic bond funds are more volatile than the short or medium-duration funds but provide superior returns.
Fixed maturity plans-
The fixed maturity plans (FMPs) are close-ended funds, don’t have interest rate risk, and invest in securities whose maturity matches the tenor of the fixed maturity plan. They don’t accept money after the NFO and the AMCs structure the scheme around the pre-identified investments.
The FMPs can provide better returns than liquid funds and ultra-short-term funds. Investors can’t redeem the units prematurely from the fund. The FMPs have a low mark to market risk. Investors can buy or sell the units only on the stock exchanges after the IPO as these are close-ended schemes.
Floating rate funds-
The floating rate funds invest in floating-rate debt securities where the interest rate changes in line with the benchmark rates or in fixed coupons which are converted to floating rates by swaps. These funds provide flexibility with the changing interest rate scenario. It is an open-ended debt scheme and should have a minimum investment of 65% of the assets in floating rate instruments. The remaining 35% is invested in fixed-rate debt instruments.
The debt mutual funds have lower risk than equity funds and are suitable for investors with a moderate risk profile. If you have got surplus spare money you can invest a lump sum amount in the fund or a systematic investment plan (SIP) can also be done. Selecting the right debt fund depends on the investment goals, time horizon, and risk profile of the investor. They can be a good source to diversify investment in case the portfolio is heavily loaded in favor of equities and can help to cushion the fall in returns.
Also, Read -The types of equity mutual funds, their benefits, and risks.