Did you know how to select the right debt funds for you?

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Though awareness about investments and mutual funds among retail investors have increased a lot in the last few years, awareness of debt mutual funds is still unfortunately quite low. There are several reasons why debt mutual funds are not nearly as popular as equity mutual funds. Firstly, investors traditionally had a risk – free, assured return mind set for their fixed income investments. Secondly, the distribution channels of traditional fixed income products, e.g. the banks, post office, etc. are much larger than that of mutual fund distribution channels. Thirdly, unlike equity funds, debt funds seem complex to retail investors and they find it difficult to match debt fund products with their needs. In this article, we will discuss various types of debt funds, their characteristics and investment needs that these funds can fulfil.

Money Market Mutual Funds

Money market mutual funds invest in money market instruments like commercial papers, certificates of deposits, treasury bills etc. These funds have very low risk and very high liquidity. There are two types of money market mutual funds – liquid funds and ultra-short term debt funds. Liquid funds invest in money market securities, whose residual maturities are 90 days or less. Accordingly, these funds are suitable for parking your funds for a few days up to 3 months or so. Liquid funds, as the name suggests, offer very high liquidity. There is no exit load and redemption instructions are processed (funds credited to your bank account) within 24 hours on business days. Some liquid fund schemes offer instant redemption, for transactions made through the AMC website or mobile application.

Ultra-short term debt funds invest in money market securities, whose residual maturities range from 90 days to a year. You can get better returns by parking your money in ultra-short term debt funds for 3 months to upto a year. Both liquid funds and ultra-short term debt funds, historically have given much better returns than savings bank interest. Ultra-short term debt funds usually give higher return than liquid funds.

Short term debt funds

Short term debt funds invest in government bonds and non-convertible debentures (corporate bonds). The maturities of the underlying fixed income securities of short term debt funds are typically around 2 to 3 years. Due to the short maturities of the underlying securities and the hold to maturity or accrual strategy used by the fund managers of these types of debt funds, short term debt funds have limited interest rate risk. Short term debt funds historically have given higher returns than Fixed Deposits of similar tenures.

Though short term debt funds have limited interest rate sensitivity there can be price volatility at the time of interest rate changes. Therefore, investors should match their investment tenures with the maturity profiles of the short term debt funds they are planning to invest in. Investors should also be aware of the credit risk.

Short term debt funds which invest only in government bond have no credit risk; these funds are also known as short term gilt funds. Short term debt funds which invest primarily in non-convertible debentures are known as corporate bond funds. Corporate bonds give higher yields compared to government bonds of similar maturities, but they are subject to credit risk. Usually fund managers try to limit credit risk by investing in high quality papers (AAA, AA etc.); however, some fund managers may try to capture higher yields by investing in slightly lower rated papers. These funds which invest in slightly lower rated papers are known as credit opportunities funds. You can select short term debt funds, based on the risk / return trade-off that you are comfortable with.

Long term debt funds

Long term debt funds invest in long maturity bonds, both Government and Corporate. These bonds can give higher yields than short term bonds, but they are subject to interest rate risk. Interest rate risk can work both ways. If interest rate goes up, the price of long maturity bonds and the NAVs of long term debt funds fall. If interest rate falls, the price of long maturity bond and the NAVs of long term debt fund rises. You should have a long investment horizon of three years or more for long term debt funds, because over a long investment horizon, there are periods of both rising and falling rates and their opposing effects cancel out each other.

There can be different types of long term debt funds depending on the nature of underlying securities and investment strategies. Long term Gilt funds invest in long maturity Government bonds. These funds are highly sensitive to interest rate changes. Income funds can invest in both Government bonds and NCDs; they benefit from both duration calls (profiting from interest rate changes) and income accrual. Strategic bond funds employ a flexible strategy depending on the interest rate environments.

Long term debt funds are good investment options for investors who are ready to remain invested for three years or more. They can give both income and capital appreciation to investors. Investors can also benefit from the long term capital gains tax advantage of debt funds, if they remain for more than three years. Long term capital gains in debt funds are taxed at 20% after allowing for indexation benefits. The tax advantage of debt funds make them attractive investment options compared to traditional fixed income schemes.

In this article, we discussed different types of debt funds and their suitability for various investment needs, so that you can select the right debt fund for your investment.