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Do you know how to select debt funds: types of Debt funds

In the last blog post - Do you know how to select Debt funds: Understanding the risk - we
discussed various types of risks that may be associated with investing in debt funds. We also
discussed how the debt funds are much more predictable than equity funds and understanding the
risk of debt funds vis-a-vis equity funds.

In this post we will understand the various types of debt funds and how these can be ideal for your
different investment needs.

Different Types of Debt Funds

We will now discuss different types and how they address different investment needs.

Gilt Funds: Gilt funds invest in Government securities with varying maturities. Since these funds
invest in Government securities there is no credit risk. However, they can be susceptible to
interest rate risks, depending on their average durations. Gilt funds can be either short term or
long term. Short term gilt funds are much less volatile than long term gilt funds, in different interest
rate scenarios. However, over a long investment horizon, say 5 years or more, long term gilt funds
can give higher returns.
Income Funds: Income funds invest in a variety of fixed income securities such as bonds,
debentures and government securities, across different maturity profiles.Their investment strategy
is a mix of both hold to maturity (accrual income, low interest rate risk) and duration calls (high
interest rate risk). These funds are suitable for investors who have a long investment horizon,
appetite for volatility and need for income during the investment tenure. Investors should have a 2
to 3 years or more investment horizon for income funds.

Short Term Debt Funds: Short term bond funds invest in Commercial Papers (CP), Certificate of
Deposits (CD) and short maturity bonds. The average maturities of the securities in the portfolio of
short term bond funds are in the range of 1 3 years. The fund managers employ a predominantly
accrual (hold to maturity) strategy for these funds. Since average maturity is low (low duration)
interest rate risk is limited. This fund is suitable for investors with low risk appetite and short
investment tenures (e.g. 1 to 2 years). Investors with long investment tenures, expecting a certain
degree of stability in income can also invest in short term debt funds. However, such investors
should have a reasonable income expectation because the yields (and consequently, fund returns)
will fall when interest rate falls.

Credit Opportunities Funds: Credit opportunities fund, also known as corporate bond funds, are
similar to short term debt funds. The fund managers lock in a few percentage points of additional
yield by investing in slightly lower rated corporate bonds. However, when investing in these funds,
you should be mindful of the risks associated with sudden ratings downgrade. These funds are
suitable for a two year or so investment tenure.

Fixed Maturity Plans: Fixed Maturity Plans (FMPs) are close ended schemes. In other words
investors can subscribe to this scheme only during the offer period. The tenure of the scheme is
fixed. FMPs invest in fixed income securities of maturities matching with the tenure of the scheme.
For example, if the tenure of an FMP is 1100 days, then the fund manager will invest in bonds
which will mature in 3 years and hold them to maturity. This is done to reduce or prevent re-
investment risk. Since the bonds in the FMP portfolio are held till maturity, there is no interest rate
risk. The returns of FMPs are very stable.Since these funds have fixed tenures of three years or
more, investors stand to gain from long term capital gains tax advantage of debt funds. Long term
capital gains of debt funds are taxed at 20% with indexation.

Money Market Mutual Funds: These funds invest primarily in money market instruments like
treasury bills, certificate of deposits and commercial papers and term deposits, with the objective
of providing investors an opportunity to earn returns, without compromising on the liquidity of the
investment. There are two types of money market mutual funds liquid funds and ultra short term
debt funds. Liquid funds invest in money market securities that have a residual maturity of less
than or equal to 91 days. These funds give higher returns than savings bank and are suitable for
investment tenures ranging from a few days or weeks or months. There is no exit load.
Withdrawals from liquid funds are processed within 24 hours on business days. Ultra-short term
debt funds invest in money market securities with residual maturities ranging from 3 months to a
year. These funds can give higher returns than liquid funds. These funds are suitable for
investment tenures ranging from 3 to 12 months.

Conclusion

In this series of two posts, we tried to demystify debt funds with the objective of making you a
smarter debt fund investor. Once you have a clear grasp of how these funds work, you will not find
debt funds too abstruse and complex to match with your own various investment objectives. In this
blog post, we have discussed how different types of debt funds can be suitable for your investment
needs. In the next post, we will discuss some useful analytical concepts of debt funds, which will
hopefully make you a better debt fund investor.

Mutual Fund Investments are subject to market risk, read all scheme related documents
carefully

Author Details

Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13

years of management experience, mostly in MNCs like American Express and Ameriprise
Financial, both in India and the US. In his last role, he was the Chief Financial Officer of
American Express Global Business Services in India. His key interests are building best in
class organizations, corporate governance and talent development