Section criteria of a debt fund

There are a number of debt fund types on offer for equity-averse investors. Before you put your money in one, ensure that you understand the scheme type and judge its suitability to your needs.

Debt is the darling of risk-averse investors. Incidentally, a majority of people are risk-averse. That is the reason why banks and post office have been able to garner large amounts of money from investors. There is another debt investment opportunity available to investors, which is through mutual funds. One can invest in debt mutual funds to remain in debt and yet attempt to improve returns. However, there are a variety of debt funds available to choose from. Here is a brief on each fund type and which investors it is suitable for.

Liquid funds

There were about 50 liquid funds currently. Liquid funds usually invest in non-convertible debentures, fixed deposits, bonds, floating rate debt, etc. Most of the securities liquid funds invest in are rated. Most of the debt securities that liquid funds invest in have a maturity period of between 1 and 256 days. This short maturity period helps the fund manager honor redemption requests.

This fund type is suitable for investors who want to park their money in a safe investment option for a short period of time.

Average returns offered by this category in the one-year period ending last December were 5.84 per cent.

Gilt funds

There are about 54 gilt funds as of late
There are two kinds of gilt funds – short-term gilt funds and long-term gilt funds. While short-term gilt funds invest in government securities with short tenures, long-term gilt funds invest in government securities with long tenures, which can even go up to 10 years. The average maturity period of long-term gilt funds can be as high as about 11 years while that of short-term gilt funds is about 2 years. While gilt funds are completely safe, i.e. they don’t suffer from credit risk (since they are issued by the government), they do carry an interest rate risk (NAV of gilt funds rise when interest rates fall and vice versa).
Gilt funds are suitable for investors who expect interest rates to fall and want to cash in on this without taking on a credit risk.

Average returns offered by this category in the one-year period were 4.19 per cent.

Income funds

There were about 51 income funds.
Income funds invest in non-convertible debentures, fixed deposits, bonds, government securities, floating rate debt, etc. Most of the securities invested in are rated. The average maturity period of securities invested in by income funds can be as high as 7-8 years.

Income funds are suitable for investors who want to remain in debt for a fairly long period. This helps the investor reduce the interest rate risk since he/she is unaffected by the short-term volatility in interest rates.
Average returns offered last year was 4.88%.

Floating rate funds (FRF)

There were about 37 FRF as on 25th December 2006. FRF have been categorized as short-term FRF and long-term FRF. While short-term FRF invest in floating rate debt securities of short tenures, long-term FRF invest in floating rate debt securities of long tenures.

Since FRF invest in floating rate securities where the interest paid on the security is reset periodically depending on changes in market interest rates, they are suitable for investors who want to invest in debt securities without taking on an interest rate risk.
Average returns about 6.25 per cent.

Short-term debt funds (SDF)

There were about 22 SDF at the end of last year.
Short-term debt funds invest in non-convertible debentures, government securities, fixed deposits, etc. They have a maximum average maturity period of about 1.5 years.

Investors in these funds are exposed to a credit risk as well as an interest rate risk. These are suitable for investors who expect interest rates to fall over their investment term and are willing to take on a credit risk to get better returns (a debt security with a higher risk will offer a higher interest rate).
Average returns were 6.08 per cent.

Fixed Maturity Plans (FMP)

FMP are debt funds which are usually close-ended. FMP are comparable to bank fixed deposits since they invest in securities whose tenures approximately match that of the fund’s tenure. When you invest in an FMP, check with your mutual fund distributor the indicative return on the FMP. FMP have been gaining significant popularity with investors since they offer safety and work in a ‘bank deposit-like’ way.

FMP have been offering about 5-6 per cent returns over a one-year period. However, since dividends declared by FMP are tax-free in the hands of the investors, FMP score over bank deposits (interest accrued on bank deposits is fully taxable).
FMP are suitable for investors who want a tax-efficient alternative to bank deposits.

Investing in debt does not mean ‘no risk’. There is the risk of capital erosion, and also lower income, due to changes in interest rates. Understand the debt investment option before putting your money in it.

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