September 16 , 2013
Among retail investors in India, debt mutual funds are in the backseat as against equity funds. Very little is written or said about them and they are not marketed aggressively owing to less distributor commission. However, things are changing with general rise in awareness levels among retail investors; many of them are willing to look beyond bank deposits to debt funds.
Classification of debt funds is as diverse as that of equity funds but understanding the basis will help in choosing the ones best matching requirements. There is no hard and fast rule on how the different types of debt funds in market are classified however broadly it is based on duration of underlying debt securities, ownership of securities and how the funds are managed.
Types of debt funds based on duration of securities
i. Liquid funds
This class of funds invests in money market instruments, which are extremely short-term fixed-income securities, like certificate of deposit, reverse repo, commercial paper, t-bills and so on. Maturity of underlying securities in liquid funds is usually less than 91 days.
Liquid funds are the most liquid of all funds; you can get redemption proceeds the next day. They have no exit load. Therefore, liquid funds can be a substitute for savings account. Their returns can be expected to be higher than what a regular savings account would pay.
ii. Ultra short term funds or liquid plus funds
Underlying securities in these funds would be money market instruments, debentures, bonds having slightly higher duration- 3 months to 1 year. Again, ultra short term funds could be a substitute for savings account or for parking funds in the short term before moving them systematically to equity funds via STP.
iii. Short term funds
Those debt funds investing in securities like bonds, certificate of deposit, repo, government securities, government loans, debentures etc, having duration of 1 year to 5 years are classified as short term funds.
iv. Long term funds or income funds
Income funds have the highest duration, could be over 10 years. They invest predominantly in long-term bonds, debentures and government loans.
There can be mismatch in names of debt funds and their classification in mutual fund research websites. For instance, a fund named XYZ short term fund could be classified as ultra short term fund on Valueresearch for lack of uniform convention for classification. So do not simply go by the name.
Ideally, debt fund investors should pick up funds having duration matching their time horizon. Being invested in a liquid fund with a 2-year timeframe or in an income fund with a 2-month timeframe will not give the best results.
Types of debt funds based on ownership
Gilts are the name for government dated securities having maturities ranging from 1 year to even 30 years. Gilt funds invest in such gilts or G-secs. On an average, a gilt fund would have duration of 5+ years. Being government securities these are risk-free but their long term yield depends on market interest rate movements.
Sometimes gilt funds are further classified as short term gilt funds and long term gilt funds.
Types of debt funds based on management
i. Dynamic bond funds
This is one category of debt funds where fund managers take active calls on what type of debt securities to buy and when to sell them. Their duration can vary depending on fund managers outlook on interest rate movements.
These funds are well suited to investors looking for medium term debt investment.
ii. Fixed Maturity Plans (FMPs)
These funds are closed-ended. One has to buy them at the start and exit at maturity. Underlying securities are held to maturity.
Choosing debt funds
We might add that superior returns are not the only criteria to look for while choosing between debt funds and traditional FDs. Taxation is another important factor. This is covered in a separate article.