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Introduction to debt funds
October 1, 2009

The article is on the difference between investing into debt funds and bonds, also the article introduces to the most common types of debt funds in India

Author : Manjunath Gaddi

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Debt funds are the mutual funds which invest into a variety of debt securities like treasury bills, government securities or gilts, Certificate of Deposits (CDs), Commercial Papers (CPs), bonds and money market securities and many more.

Investing into debt funds is somewhat different from investing into a bond or a debt security directly. Especially in India, where the debt markets are underdeveloped, debt funds are sometimes the only way to invest in the debt market.  

Some of the important differences between a debt fund and a bond follow:

  • It is less risky to invest into a debt fund than to invest directly into a debt security.
  • The investor of a bond or debt security gets the interest or the coupons directly, whereas an investor in a debt fund receives a dividend at the discretion of the fund house.
  • There can be times when you may not be able to sell a debt security in the debt market, or you may be able to sell only at a huge loss as there may not be anyone willing to buy. With debt funds, the fund house will always redeem your fund units at the declared NAV. 
  • Debt funds are managed by professional fund managers whose job is to track and invest in the debt market. As an individual bond investor, one may not have the time and resources to track and invest appropriately.
  • Bonds or debt securities have a maturity date but the debt funds do not have a maturity date.

Since debt funds invest into many kinds of debt securities, they are classified accordingly. Following are the most common classes of debt funds.

Liquid funds or Money Market Funds

In the world of finance, ‘liquid’ means anything that is almost as good as cash. Money market funds or Liquid funds as they are commonly known as are one of the safest places to park your money for short periods of time. The funds invest into money market securities and debt securities that mature in 91 days.

Most corporates park their short term money into these funds. Liquid funds are also suited for investors earning more than Rs 5 lacs, as returns from liquid funds are more tax efficient than the interest one can get from the savings accounts.

Some of the benefits of parking money into liquid funds are

a)      Zero exit loads

b)      Investments are very safe

c)       Money can be redeemed in 1 day

d)      Lowest expense ratio of all the mutual funds

e)      One can invest with a minimum of Rs 5,000

f)       Multiple periods of dividend reinvestment options – daily, weekly, fortnightly, monthly

Ultra Short Term funds

Ultra short term funds were earlier known as liquid plus funds and are slightly riskier in comparison to liquid funds.  The funds invest into debt securities maturing in the next one year. Since ultra short term funds are riskier than liquid funds, they tend to give slightly higher returns in comparison to liquid funds.

Ultra short term funds share most of the benefits offered by liquid funds and suit investors who want to park their money for a few months.

Floaters or Floating Rate funds

Floating rate funds or Floaters invest into floating rate debt securities. Most of the debt securities in a floater fund will mature within a year. The main benefit of investing into a floater fund is that when the RBI increases the interest rates, the interest rates on floating rate debt securities also increase, thus when interest rates are expected to rise, floaters are better debt investments than other debt funds.

 Floating rate funds invest 65% to 100% of their money into floating rate instruments and the rest in other debt securities.

 Short Term Funds

Short term funds invest in debt securities that mature in the next 15 – 18 months. They invest mostly into AAA or AA+ rated debt securities and interest rate hikes mildly impact the returns. Short term funds are best suited for investors with an investment horizon of 1 – 2 years.

GILT Funds or Government Securities (G-Secs) Funds

GILT funds invest exclusively into debt securities issued by RBI on behalf of the Government of India or the state governments.  Although there is no risk of default with G- Secs, they are not immune to the interest rate movements. Since G-Secs have no risk of default, they have a Sovereign (or SOV) rating.

 G-Secs come with a wide range of maturities, from a few days to 30 years, so many GILT funds have short term and long term plans. Short term plans invest money into G-Secs which mature in the next 15-18 months. Long term plans invest into G-Secs which mature in periods up to the next 30 years.

 Monthly Income Plans (MIPs)

Monthly Income Plans or MIPs are hybrid investment funds. They invest a minor portion (up to 15%) in equities and the rest into debt securities. They aim to provide regular and periodic income. The income periods can be monthly, quarterly, half-yearly and yearly. But a point to be noted is that the income is not guaranteed. The fund will only be able to distribute income if it has surplus distributable income. These plans are suitable for people looking for regular income rather than capital appreciation.

 Dynamic Bond Funds

Dynamic bond funds aim to bring active fund management into debt funds. They invest in debt securities with any maturity and invest across the yield curve, with the sole purpose of utilising any opportunity provided by inflation, changes in liquidity, changes in monetary policy, or government borrowing program factors. Apart from the earlier mentioned opportunities, dynamic bond funds also tend to use the inefficiency and volatility in the debt market to get better returns.

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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


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