Understanding the different types of debt mutual funds…

Most investors tend to use the term debt fund in a very generic sense. It needs to be understood that there are a variety of sub-groups within the fixed income fund space. Each of these funds typically makes sense in a specific market condition and for distinct type of need that an investors may have. Therefore one needs to understand the nuances of each of these specific categories so that one can take an informed decision on which specific type of fixed income fund to select…

Liquid Funds – Shortest end of the maturity

This is essentially a liquid cash management product. Corporates and HNIs use this method to park their funds which need to be withdrawn at short notice. Since these liquid funds do not attract entry and exit load, they permit easy entry and exit for short term investors. The maximum maturity that these liquid funds will invest is normally 91 days. They typically invest in call money market and in 91 day Treasury bills. They are the lowest risk and are not very susceptible to changes in the market interest rates.

Short term funds – Slightly longer on the maturity scale

These short term funds are slightly longer in maturity bracket compared to pure liquid funds. They typically invest in debt securities having a maturity up to 3-4 years. The short term funds are meant for investors who want to park their funds for a maximum period of 2 years. Of course, their risk is higher than liquid funds, but due to their short tenure of bonds, they are less susceptible to interest rate risk.

Arbitrage Funds – Called equity funds but behave like debt funds

Arbitrage funds actually mirror a debt product by being long on equities and creating a short position in futures. This way they create a mirror of a 1 month debt product that can be rolled over infinitely. These funds are classified as equity funds and hence they are tax efficient from an investor’s perspective. But these funds are not always attractive. It largely depends on the equity-futures spread in the market. If the spread compresses, then most investors lose interest in these arbitrage funds.

Bond Funds – Invest in private sector bonds and gilts

Bond funds are long term debt funds which invest in debt instruments that have longer maturities. These funds typically invest in private debt, quasi institutional debt, and state government debt and in gilts. These funds are susceptible to interest rate risk. Therefore it makes sense to invest in these products when you have the view that interest rates are going to fall. Otherwise it may result in capital losses. On needs to remember that Bond funds have an element of default risk too as there are private sector bonds that are also included in their portfolio. We saw this risk manifest itself recently in the JP Morgan Mutual Fund’s holdings in the bonds of Amtek Auto.

Gilt Funds – Focus on G-Secs

Gilt funds are almost similar to bond funds. The only difference is that they do not invest in private bonds but only in government debt. They are also funds that invest in long tenure bonds. While these gilt funds carry a high level of interest rate risk, they are not exposed to default risk, since there is no risk of default in the case of government securities. These are the most popular among the corporate and institutional investors.

Fixed Maturity Plans (FMPs)

These are almost akin to closed-ended funds. Here the fund has a specific maturity and can be redeemed only at that particular maturity. Hence investors need to understand that the asset liability mismatch does not happen to them. For example, if you have a liability maturing in 2 years, no point in creating a 3-year FMP. Of course, these FMPs are listed on stock exchanges but then there is an additional cost that it involves.

Floating Rate Funds

These are funds where the interest yield is reset at regular intervals. This makes sense in a rising interest scenario, where investors can get the benefit of higher yield and they do not suffer capital loss as in case of bond funds and gilt funds. This is a good product to manage interest rate risk in a rising interest environment.

Monthly Income Plans (MIPs)

These are debt funds that also have an exposure to equity in small measure to provide that additional return kicker. These MIPs have a monthly payout and hence operate as a kind of a systematic withdrawal plan for investors. It needs to be remembered that these are not assured return schemes and they will vary based on the performance of the MIP.

As an investor it is necessary for you to understand the nuances of the various categories of fixed income funds so that you can pigeonhole your choice of fund to your exact requirement and your view on interest rates.

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

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