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Debt fund types

Investors have plenty of choices when it comes to mutual funds and it’s not difficult find one that meet their investment goals and the risk they are prepared to accept. Among the different types of funds is the debt fund, which is meant for those who want steady returns but do not want the risk involved in equity investments. Debt funds invest in fixed income instruments that include government securities, commercial paper, treasury bills, corporate bonds, money market instruments and other debt of varying maturities. There are many debt fund types to suit varying investment goals.

Debt funds invest in fixed income instruments of varying maturities. Many of these, like government bonds, are not available to individuals but only to institutional investors. So individual investors are not able to realise gains from investing in them. And it’s a big market since the government is the largest borrower in the market!

Debt funds do not always hold bonds till maturity and sell them before that for a margin. The gains that the mutual fund makes by this buying and selling is passed on the investor in the form of higher net asset values or NAVs. Fund managers also reinvest the interest received in debt funds, thus increasing the size of the corpus.

Debt funds also make money on interest rate movements. When interest rates fall, debt funds make money. Let’s explain how this works. Let’s assume that a debt fund holds government bonds that carry an interest rate (or coupon rate) of 10 per cent. Later the government decides to issue bonds at 9 per cent. What this means is that the value, or yield, of the 10 per cent government bonds goes up, and the debt fund is able to sell them at a profit and make gains for investors. The converse is also true, of course. When interest rates fall, so does the value of the debt fund’s holdings. So the NAVs will also fall.

There are many debt fund types depending on varying investment goals, time horizons and investment goals. These include liquid funds, income funds, gilt funds etc. Let’s take a look at the different debt fund types.

Liquid funds

This is one of the debt fund types that are suitable for investors who want to park funds for short periods. Investments could be as short as a day! Liquid funds invest in fixed income instruments with very short maturities of up to 91 days, like treasury bills, certificates of deposit and commercial paper. The focus of these funds is basically capital protection, rather than ensuring high returns. So fund managers tend to err on the side of caution and invest only in those instruments that have a high credit rating. Mutual fund companies try to keep costs to a minimum so that investors don’t have to pay high expense ratios and reduce their returns.

Ultra short term funds

These debt fund types are similar to liquid funds. These funds invest in fixed income instruments of a very short duration with a certain portion in longer-term securities. Generally, the instruments do not have a residual maturity of over a year. Ultra short term funds are aimed at investors who want to park money between one and six months.

Overnight fund

These debt fund types are a variation of liquid fund; you can call it an ultra-liquid fund. These invest in debt and money market instruments of overnight maturity.

Gilt funds

Gilt funds invest in central and state government securities that have a medium and long term tenure. These debt fund types are aimed at investors with a longer-term perspective. Since the securities these funds invest in are guaranteed by the government, there is no risk of default. So to that extent they are free from risk. However, gilt funds are not immune from interest rate risk. When interest rates rise, yields go down as do the net asset values (NAVs) of gilt funds. Higher the maturity profile of these instruments, higher the risk.

Corporate bond fund

A corporate bond fund, as the name suggests, invests in the debt of companies that want to raise money to meet their working capital requirements or for capital expansion. This kind of debt is also known as non-convertible debentures. These are suitable for investors who want a higher rate of return than, say, gilt funds. Returns on these debt fund types depend on the kind of paper they invest in. For instance, a fund that invests in corporate debt with low ratings could offer higher returns, but will take on higher risks. The risks are mainly in the form of defaults, which will be on the lower side if the fund invests in debt with high credit ratings. These debt fund types are suitable for investors with a longer time horizon.

Income funds

Among the more popular debt fund types is the income fund, which is preferred by investors who do not want to take much risk and enjoy a stable income over the longer term. Income funds invest in a mix of government securities and corporate paper with maturities of around five years. Of course, like gilt funds, income funds too are subject to interest rate risk.

Money market funds

A money market fund invests in fixed income instruments of short maturities and minimal credit risk. These debt fund types invest in commercial paper, commercial bills, certificates of deposit and treasury bills, with maturity periods of up to a year.

Credit risk funds

These debt fund types are meant for investors who are willing to take on more risk in the hope of making higher returns. Credit risk funds invest in paper that have a lower credit rating. Companies issuing such paper have to offer higher interest rates to attract investors, so returns are higher here. These funds were earlier called credit opportunities funds but Sebi has now asked them to be renamed credit risk funds. These funds generally hold the securities till maturity. The problem with these funds is the lack of liquidity. If funds face redemption pressure, they will have to sell securities at high yields, thus lowering NAVs. And there is also the risk of default.

Banking and PSU funds

These debt fund types invest most of their assets under management in the debt instruments of banks, public sector undertakings, and public financial institutions. These include certificates of deposits (CDs), commercial paper (CP) and PSU bonds with medium term maturities. Banking & PSU funds involve lower levels of risk and are suitable for investors who would, for instance, put their money in bank fixed deposits. There are indexation benefits, so you may have to pay less tax if you hold these funds for over three years.

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Floater funds

Floater funds invest in instruments that have a floating interest rate. These debt fund types are suitable for investors keen to avoid interest rate risk, especially in a rising rate scenario. The fund manager invests mainly in instruments that have medium and longer term maturities.

Arbitrage funds

Arbitrage funds are among those types of mutual funds that many investors may be unfamiliar with. These mutual funds take advantage of price differences between the derivatives and cash segments of the stock market. However, arbitrage opportunities are not available all the time, so to ensure steady returns to investors, arbitrage funds place part of their corpus in fixed income instruments.

Fixed maturity plans

Fixed maturity plans or FMPs are among the debt fund types that are close ended. Which means that they invest for a certain fixed period of time. FMPs invest in fixed income instruments and offer stable returns for risk-averse investors. They are available for varying periods of time, ranging from 30 days to several years. FMPs have some tax benefits compared to fixed deposits. If you hold them for over three years, you get indexation benefits and could end up saving some tax. Of course, returns in FMPs, unlike a fixed deposit, are only indicative and may not always be what you expected.

Hybrid fund/ Balanced fund

A hybrid or balanced fund invests in multiple asset classes to meet the need for varying investment objectives and risk appetite. A balanced fund may invest in a mix of debt and equity. This is among the types of mutual funds that is preferred by conservative investors who want to enjoy the steady returns and low risk that a debt fund involves, combined with the high-return-high-risk profile of an equity fund. Generally, balanced funds in India invest 60 per cent of their corpus in debt and 40 per cent in equity. A conservative fund may invest less in equity and more in debt.

Finding the right debt fund

It’s sometimes difficult for investors to figure out which debt fund types to invest in. The choices will depend on the investment objective, risk appetite and the need for liquidity. The AngelBee mutual fund investment app will help you find the best mutual fund in each category so that you can maximise returns and minimise risk.

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