In this article, I will cover
various types of Debt Funds and how these can be useful for your different
investment needs.
Different Types of Debt Funds
Let me discuss different types of
Debt Funds and how they address your different financial needs, based on your
investment horizon.
Long
term Debt Funds (Dynamic Bond Funds):
These funds invest in Government
securities with varying maturities. Since these funds invest in Government
securities there is no credit risk. However, they can be susceptible to
interest rate risks, depending on their average durations. Over a long
investment horizon of 5 years or more, long term debt funds can give higher
returns as compared to other types of debt funds. Investor should have at least
2 to 3 years or more as investment horizon for investing in Long Term Debt
Funds or Dynamic Bond Funds.
Income
Funds:
Income funds invest in a variety of
fixed income securities such as bonds, debentures and government securities,
across different maturity profiles. Their investment strategy is a mix of both
hold to maturity (accrual income, low interest rate risk) and duration calls
(high interest rate risk). These funds are suitable for investors who have a
long investment horizon, appetite for volatility and need for income during the
investment tenure. Investors should have 2 to 3 years or more as investment horizon
for income funds.
Short
Term Debt Funds:
Short term Debt Funds invest in
Commercial Papers (CP), Certificate of Deposits (CD) and short maturity bonds.
The average maturities of the securities in the portfolio of short term debt
funds are in the range of 1 to 3 years or marginally higher. The fund managers
employ a predominantly accrual (hold to maturity) strategy for these funds.
Since average maturity is low (low duration) interest rate risk is limited.
This fund is suitable for investors with low risk appetite and short investment
tenures of 1 to 3 years. Investors with long investment tenures, expecting a
certain degree of stability in income can also invest in short term debt funds.
However, such investors should have a reasonable income expectation because the
fund returns will fall when the interest rates in the economy falls. This
happens because since these funds hold their investments till maturity, so if
the interest rates of the underlying Commercial Papers (CP), Certificate of
Deposits (CD) and short maturity bonds fall, the returns of these short-term
debt funds will also reduce.
Fixed
Maturity Plans:
Fixed Maturity Plans (FMPs) are
close ended schemes. In other words, investors can subscribe to this scheme
only during the offer period. The tenure of the scheme is fixed. FMPs invest in
fixed income securities of maturities matching with the tenure of the scheme.
For example, if the tenure of an FMP is 1100 days, then the fund manager will
invest in bonds which will mature in 3 years and hold them to maturity. This is
done to reduce or prevent re-investment risk. Since the bonds in the FMP
portfolio are held till maturity, there is no interest rate risk. The returns
of FMPs are very stable. Since these funds have fixed tenures of three years or
more, investors stand to gain from long term capital gains tax advantage of
debt funds. Long term capital gains of debt funds are taxed at 20% with
indexation provided you buy and hold these funds for a period of over 3 years.
FMP do not have any flexibility to redeem all the funds or the partial funds, and
you have to hold it for the entire duration of the FMP. Hence, it is suitable
for only those investors who are willing to lock that money for entire FMP
duration, and is not suitable for those who are looking for regular returns.
Liquid
Funds and Ultra-short-term Debt Funds:
These funds invest primarily in
money market instruments like treasury bills, certificate of deposits and
commercial papers and term deposits, with the objective of providing investors
an opportunity to earn returns, without compromising on the liquidity of the
investment. There are two types of money market mutual funds – liquid funds and
ultra short term debt funds. Liquid funds invest in money market securities
that have a residual maturity of less than or equal to 91 days. These funds
give higher returns than savings bank account and are suitable for investment
tenures ranging from a few days or weeks or months. There is no exit load.
Withdrawals from liquid funds are processed within 24 hours on business days.
Ultra-short-term debt funds invest in money market securities with residual
maturities ranging from 3 months to a year. These funds can give higher returns
than liquid funds. These funds are suitable for investment tenures ranging from
3 to 12 months.
Broadly,
you can refer the following thumb rules to decide the type of Debt Fund
suitable for you.
|
Investment horizon
|
Type of Debt Fund most
suitable
|
Debt Funds in this category
|
|
1
Month to 3 Months
|
Liquid
Fund
|
HDFC
Cash Management Fund – Savings Plan
|
|
3
Months to 12 Months
|
Ultra-short-term
Debt Fund
|
L&T
Ultra Short-Term Fund
|
|
12
Months to 36 Months
|
Short
term Debt Fund
Or
Income fund
|
ICICI
Prudential Short Term Fund
|
|
More
than 36 Months
|
Long
term Debt Fund or Dynamic Bond Fund
|
Aditya
Birla Sun Life Dynamic Bond Fund
|
(Note:
Mutual Fund names listed above are for the purpose of illustration only, and
you should consult your financial advisor before making any investments).
Nature of risk in Fixed Income Investing
Let us spend a few minutes
understanding the fundamental nature of risk in fixed income investing.
There are basically three kinds of
risk in fixed income.
- Interest rate risk:
Interest rates are related to bond prices. Bond prices
increase with decrease in interest rate and decrease with increase in interest
rates.
- Credit risk:
Credit risk in the context of debt funds is the impact of
change in credit ratings on bond prices. Bond price will fall if credit ratings
worsen and rise if the ratings improve.
- Re-investment risk:
Re-investment risk refers to risk of re-investing bond
maturity proceeds at a lower yield than before.
Selecting
debt funds based on risk appetite
- If you have to redeem
your investment, partially or fully, at short notice, then you need high
degree of capital safety and liquidity. Liquid and ultra-short-term Debt
funds are very little affected by changes in long term yields in the short
term. Since the tenure of the investments made by these funds are for
short term, there is no re-investment risk. Credit risk is also minimal
because issues of highest credit quality are able to access Money markets.
If you think, you may have to redeem your investments within a few weeks or months then liquid funds are the best investment option. Liquid fund is a much better option to park your funds for a short period than your savings bank account. They offer very high degree of capital safety and liquidity. In the last 5 years, liquid funds gave negative weekly returns only once, in 2013 that too in extra-ordinary global monetary circumstances, when the Federal Reserve in the US began to taper its bond purchase programme.
If you think, you will not need the money for the first three or four months after investment, but anytime afterwards, then ultra-short-term debt funds are the best investment choices. Ultra-short-term debt funds are money market mutual funds and very similar to liquid funds in terms of risk characteristics. They usually give higher returns than liquid funds, but can have some very short-term volatility in returns.
- If you want high
degree of capital safety but do not need money at short notice, then you
can afford some very short-term volatility, provided the risk over your
investment tenure is very low. Short term debt funds with the highest
credit quality are ideal for risk-averse investors over one to two year
investment tenure. These funds hold the bonds in their portfolio to
maturity and hence, there is very little interest rate risk. By selecting
debt funds with very high credit quality, you can avoid credit risks.
Debt funds with high credit quality have their portfolios invested in mostly Government and AAA or AA rated corporate bonds. Government bonds come with sovereign guarantee and there is no risk of default. High credit ratings assigned to corporate bonds signify balance sheet strength of the issuer and low risk of default. Re-investment risk can be avoided by matching your investment tenure to the average maturity / duration of the fund. You can get information on the fund maturity profile of debt fund schemes in the monthly factsheets published by the AMCs. Also, you can get this information on various other financial web sites such as https://www.valueresearchonline.com.
- If
you have a longer (preferably 3 years or more) investment tenure and are
not bothered by short term volatility, then you can invest in income funds
and long-term debt funds to get higher returns. You should understand the
concept of risk in the context of investment tenure in fixed income
investing. By risk, we are referring to interest rate risk here, because
you can avoid credit risk by selecting a fund whose credit quality is very
high and re-investment risk is irrelevant because your investment tenure
is likely to be less than bond maturity period. Here, I am suggesting an
investment horizon of over 3 years, to ensure that, short term volatility
in the bond prices should not affect your returns and also you will not
incur any short-term capital gains tax. If you redeem your investment
after a period of 3 years, then any profit made will be considered as long-term
capital gains which is taxed at the rate of 20% with indexation benefits.
Comments
Post a Comment