The Hindu Business Line : Know your debt fund options

The equity market has belied investors’ hope of a quick revival, what with the correction that started in January 2008, showing no clear signs of waning. However, given the interest rate movement over this period, those who had invested in debt instruments would have derived some comfort.

Apart from the traditional fixed deposits and provident fund schemes, mutual funds too actively manage debt products. Here is a look at the broad categories of debt funds and the kind of instruments they invest in. Debt funds seek to invest in various debt instruments whose maturity could be short-term or long-term. Debt funds can be broadly classified as income funds, liquid funds and fixed maturity plans. The classification is based on the nature of instruments and their maturity.

Return potential: Income funds or bond funds are typically open-ended and seek to generate capital appreciation by investing in medium- or long-term bonds, debentures or certificates of deposits (issued by banks and financial institutions).

Even as an income fund seeks to preserve capital, there is no guarantee that one would not lose money.

The credit quality of the instruments and the fund manager’s ability to tactically manage the portfolio maturity based on interest rate cycles would determine the performance of such funds. While flexi-income funds tweak their average portfolio maturity to benefit from interest rate cycles, funds that have a mandate to invest in short- or long-term-only instruments may have to manage within such a mandate. These funds, therefore, bear risks arising from different interest rate regimes.

Safer avenue: Gilt funds, on the other hand, are safer options as they invest in government securities and treasury bills. Sovereign guarantee is the key attraction in gilt funds.

However, these funds are also not risk-free/optimal-return instruments. A turn in interest cycles can harm the portfolio returns if the fund manager is unable to anticipate the move and invest accordingly.

The key difference between income and gilt fund is that in the former, default of the bond issuer in case his creditworthiness deteriorates, can affect returns.

Income funds could, therefore, be termed as relatively high risk, high return instruments compared to gilt funds.

Parking ground: Liquid funds, as the name suggests, invests in instruments that allow the fund to provide easy exit options for investors. In other words, these funds are typically used largely by corporate/institutions and also retail investors to temporarily park surplus funds and provide returns superior to savings bank interest.

Liquid funds typically invest in money market instruments such as treasury bills, certificates of deposits and commercial papers (issued by highly rated corporates to meet their short-term borrowings). Being highly liquid, the maturity of the underlying instruments most often varies between a few months to less than a year.

As these funds have restrictions on the quantum of investment in mark-to-market instruments, the interest rate risk is lower. They do not, therefore, benefit from interest rate cycles, unlike income or gilt funds. Liquid-plus funds, on the other hand, can invest in slightly longer-term maturity instruments, thus enhancing the risk-return potential.

Tax efficient: Fixed maturity plans are close-end funds whose maturity is linked to the expiry of the underlying instruments in which they invest.

Most fixed maturity plans invest in debt, while a few allocate a portion to equity to enhance returns. These funds state the broad universe of funds in which they invest.

While FMPs typically help investors lock into the yields of the underlying instruments, such returns would be feasible only if an investor holds on to the fund, until its maturity. Further, the credit quality of the FMPs’ investments is suggestive of the risks undertaken.

For instance, investments made by some FMPs in small real estate firms have led to panic and sharp outflows in some funds, what with the downturn in the realty sector. Fixed maturity plans are often compared with fixed deposits for showcasing superior yields from the former.

While FMPs are no doubt a superior option from a taxation perspective, they are not strictly comparable, as fixed deposits offer assured returns and are not directly linked to market sensitivities once the investment is made.

Monthly Income Plans or MIPs are not full-fledged debt funds. These funds can hold about 5-25 per cent in equities and the rest in debt. As the name suggests, MIPs seek to provide monthly/quarterly/half-yearly or annual returns (based on the option chosen).

However, investors should bear in mind that there is no assurance of providing regular returns. MIPs are, therefore, no substitute for other monthly income options such as the post-office or bank fixed deposits. They are, however, more tax-efficient given that the monthly income/dividend is free of tax.

MIPs invest in a combination of floating rate debt instruments or fixed rate instruments depending on interest rates. Further, unlike other debt funds, MIPs carry higher risks depending on their exposure to equity.

Investors need to note that debt funds are not risk-free assured return instruments. The debt market too, is vulnerable to various risks that can drag returns. We shall discuss these risks in the forthcoming edition.