Understanding debt funds

There are various types of debt funds available for investment. Each type has its own unique characteristic making it suitable for a particular investment requirement.  The investment portfolio held by the fund plus the nature of the fund in terms of risk and expected returns are factors that will determine the suitability of the instrument. Here is a look at the various types of debt funds on offer.

Liquid/ Money market funds

These are debt mutual funds that are available for very short term investments. They offer the benefit of an easy entry and easy exit so that if there is money that has to be parked for a few days or even a few weeks. These funds invest their amounts in overnight call money market and other very short term instruments including certificates of deposits and commercial paper.  The nature of the instruments should ideally result in no interest rate risk but there is credit risk present as the issuer of the instruments can default on the payments.  These funds have returned around 4.5-5.0 per cent per annum over the last one year.

Short term funds

There are funds that have a portfolio that is suited for slightly longer time duration than the liquid funds and these are known as short term funds. This makes the funds suitable for those who are looking to have an investment horizon for a few months and not just a few days or weeks. These funds invest their corpus in instruments like reverse repo, Certificate of Deposits, Commercial Paper, Debentures and even structured obligations of short time duration. The risk that is present in these instruments includes both credit risk as well as the interest rate risk. The returns of these funds are expected to be slightly more than that of the liquid funds and they have returned around 4.75-5.5 per cent over the last one year.

Floating rate funds

These are mutual funds that invest their corpus into instruments that have a floating interest rate. Such instruments offer partial protection against inflation risk as their rate of interest is reset taking into consideration the existing interest rate scenario. There is only a partial protection against the risk of inflation as the change in the interest rates is not instantaneous. These funds invest their corpus into floating rate instruments issued by banks, financial institutions and other entities. The return that is earned by these funds is commensurate with the rate that is present on the instruments that are used for the investment. Floating rate funds can be short term as well as long term in nature.

Income funds

These are funds that invest for the medium to long term in debt instruments. The portfolio of these funds consists of instruments like bonds, government securities and other instruments that are slightly long term in nature.  These funds have a higher credit risk because of the fact that their portfolio consists of instruments have no guarantee about repayment. At the same time the prices of these instruments are susceptible to changes in the interest rate in the economy so that when there is a rise in the interest rate the value of these instruments will fall and vice versa. This also gives rise to interest rate risk and investors will buy these funds when they expect interest rates to fall as the value of the holdings in the portfolio will rise. The rate of return in these funds has been in the range of 4.25-5.5 per cent in the last one year.

Gilt funds

Gilt funds are those mutual funds that invest their corpus in government securities. There is no credit risk in the instruments that are held by these funds in terms of repayments since there is government backing for them. However these funds can still deliver a negative return for the investor because they are subject to interest rate risk as the value of the holdings will move according to the change in the interest rates. Gilt funds are both short term as well as long term in nature. Rising interest rates has impacted the returns from these funds over the last one year and they have shown returns in the range of 3-4.5 per cent in the last year.

Monthly Income Plans

These are schemes that offer a monthly income from the earnings generated by the portfolio. The monthly payout is not guaranteed as this depends upon the earnings of the fund. These are suitable for investors who want a regular return from their investment and are willing to take some risk in the process. Around 80-90 per cent of the portfolio is invested in debt while the remaining 10-20 per cent is in equities. This has a high risk because there can be negative returns due to the fall in the value of the equity portion or even negative conditions in the debt part of the portfolio.  These funds have shown a return of 5-12 per cent in the last one year.

Fixed Maturity Plans

Fixed Maturity plans are close ended funds.  The only time when funds can be bought from the mutual fund is during the new offer period and after that the fund will not transact in the units till the date of maturity. However there is a liquidity option through the listing of the units on the stock exchange.  These are meant to be used in lieu of fixed deposits so that there is a similar kind of investment available. These funds select investments that mature exactly on the day on which the scheme will come to an end and this can be of various durations like 30 days, 180 days, 370 days and so on.
 

* Return for schemes in this category in the last one year as on November 20, 2010

Arnav Pandya is a well known Financial Planner, Trainer & Columnist.