Different investors have different investment needs depending on their financial situations, risk appetites and investment objectives. Debt mutual funds offer a spectrum of solutions for a wide range of investment needs, risk appetite and investment tenures. We will discuss about some key debt fund categories below.
These debt funds invest in fixed income instruments which mature overnight. These instruments have virtually no interest rate risk. These overnight instruments are backed by collateral which comprises of Government Securities, and so these funds also have no credit risk. These are the safest debt funds but their yield is usually also the lowest. Overnight funds are suitable for parking your funds for a few days.
Liquid funds invest in debt and money market instruments like commercial papers, certificates of deposits, treasury bill etc which mature within 91 days. Due to the very short maturities of their underlying instruments, liquid funds have very low interest rate risk. However, liquid funds may have exposure to credit risk depending on the credit quality of the underlying instruments. High credit quality liquid funds have very low risk and potentially offer higher returns than savings bank. According to SEBI directive, these funds charge graded exit loads for withdrawals within 7 days from the date of investment. Liquid funds are suitable for parking your funds for a few weeks or months.
As per SEBI’s mandate, Money Market Funds must invest in money market instruments like commercial papers (CPs), certificates of deposits (CDs), treasury bills (T-Bill) etc., having maturity of less than 1 year. These funds have moderately low price sensitivity to interest rate changes. However, these funds may be subject to credit risks depending on the credit quality of the underlying instruments of the funds. These funds are suitable for investors with moderately low risk appetites. Investors should have 1 – 2 year investment tenures for these funds.
Short duration funds invest in debt and money market instruments such that the Macaulay Duration of the portfolio is between 1 – 3 years. In simplified terms, Macaulay Duration is the interest rate sensitivity of a fixed income instrument. Due to their relatively short duration profiles, short duration funds have medium interest rate risk. These funds aim to hold the instruments in their portfolio till maturity and earn interest paid by them, aiming to give stable returns in different interest rate scenarios. Some funds can have exposure to credit risk depending on the credit quality profile of their underlying instrument. Short duration funds are suitable for 2 – 3 year investment tenures. Investors can avail of long-term capital gains tax benefits for 3 years + investment tenures.
As per SEBI’s mandate, Corporate Bond Funds must invest at least 80% of their total assets in highest rated instruments. The highest rating given by agencies like CRISIL and ICRA for corporate bonds is AAA and for short term instruments i.e. instruments with maturity of 1 year or less e.g. commercial papers, certificates of deposits etc is A1. Corporate bond funds must invest 80% of their assets in such instruments. Even though AAA and A1 denote highest degree of safety, ratings can change over time depending on the financial performance of the issuer. Investors should monitor the credit quality profile of their funds on a regular basis.
As per SEBI’s directive, Credit Risk Funds invest at least 65% of their total assets in instruments which are rated below the highest rating. In other words, AA or lower (corporate) and A2 or lower for short term instruments i.e. instruments with maturity of 1 year or less e.g. commercial papers (CP), certificates of deposits (CDs) etc. Lower rated papers give higher yields but also have higher credit risks. Investors should understand the risks in these funds before investing.
Dynamic bond funds have the flexibility to invest across durations depending on their interest rate outlook. If the fund manager expects interest rates to fall, he / she will invest in longer duration instruments to benefit from price appreciation. Likewise, if the fund manager expects interest rates to rise, he / she will invest in shorter duration instruments to get higher yields and reduce interest rate risk. Dynamic bond funds usually have high sensitivity to interest rate changes. Investors should have appetite for short term volatility and a sufficiently long investment horizon. Investors should have at least 3 years or longer investment horizon for these funds. Over investment tenures of 3 years or longer, you can get long term capital gains tax benefits. Investors can use SIP to reduce volatility which may also improve returns of the fund.
These funds invest at least 80% of their assets under management in Government Securities. Hence these funds have very low credit risk. However, these funds have high sensitivity to interest rate changes. They can give high returns when yields are falling but can be quite volatile in the short term if yields spike due to any reason. Investors should have high appetite for volatility and at least 3 years or longer investment tenures for their Gilt fund investments.
As per SEBI’s mandate, Long Duration Funds must invest in debt and money market instruments such that the Macaulay Duration of the fund portfolio is greater than 7 years. The Macaulay duration is the weighted average term to maturity of the cash flows from a bond. Macaulay duration is closely related to Modified Duration which is the price sensitivity of a fixed income instrument to interest rate changes. Long duration income funds are highly sensitive to interest rate changes. However, long duration funds usually have relatively low credit risk because these funds invest predominantly in G-Secs. Since these funds have fairly high interest rate risk, investors should have moderate risk appetites and sufficiently long investment tenures (at least 3 years).
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