Did you know that debt funds, as a category, offer a wide spectrum of products to suit your varying investment horizons? That’s perhaps the single biggest advantage that debt funds offer when compared with equity funds; the latter being mostly meant for the long term.
Agreed, their returns may not be top notch like equity, but they can be optimal given the limited time frame and relatively lower risks.More importantly, they can be tax-efficient, provide high liquidity and deliver superior returns to traditional debt products.
Here’s a quick primer of the kinds of open-ended debt funds fit your different investment time frames.
Liquid and ultra short-term funds
These funds are meant to park your money temporarily. They are the least risky and least volatile among various mutual funds; as they park money in treasury and very short-term debt instruments such as certificates of deposits and commercial papers.
Both these categories are highly suitable for short-term purpose, where the goal is to save money temporarily. If you need the money in less than three months, then liquid funds will meet the need. Ultra short-term funds are suitable for goals of six months to a year.
They are also good tools to invest money as lump sum and then transfer systematically to equity funds. They are also ideal options to supplement your savings bank account that typically yields lower return.
Conversely, you can systematically withdraw from equities when you near your goal and park your money in these funds, until you need them.
Short-term and medium-term debt funds
Short-term funds are suitable if you need to invest your money with a time frame of one to two years. These funds invest in a range of certificates of deposits, commercial papers and other short-term corporate and government bonds.
They can have a portfolio with an average maturity of up to two years. That means, in addition to holding short-term instruments, they would also hold a small proportion of debt with slightly higher maturity to seek marginally higher returns than liquid and ultra short-term funds.
It is noteworthy that a fund that calls itself short term or is classified as short-term by rating agencies may actually be a medium-term fund.
Hence, you will do well to look at the fund investment strategy in its Scheme Information Document (SID) as well as look at the exit load structure to know if it fits your time frame.
Income accrual and dynamic bond funds
These funds invest in a wide range of instruments including corporate and government bonds, debentures, certificates of deposits as well as commercial paper and money market instruments. These are mostly go-anywhere funds as far as their portfolio maturity is concerned. Most of them tend to be dynamic in terms of their maturity profile, often pegging it to the interest rate cycle.
They tend to load themselves up with long-term instruments such as gilt when the interest rate is expected to slide and go short in a rising interest rate scenario. The appreciation in your NAV comes from both income accrual (interest income from the instruments) as well as any price rally coming from a falling interest rate.
These funds may also take some credit risks. While they seek to hold a good proportion in high credit-rated instruments, they may, at times, bet on slightly lower rated instruments, hoping to see a re-rating.
All these features enhance the risk of their portfolio. Such risk arises from interest rate as well as credit quality. That means you will have to hold a longer term view to take exposure to these funds. These funds ideally require a time frame of at least 2 years and ideally 3-year plus.
But when the interest rate cycle is unidirectional for a long while, then the holding in these funds would have to be longer.
Income or dynamic bond funds are also good additions to a long-term portfolio, especially when you wish to hedge your equity portfolio with some debt exposure. In such a case, SIPs will help reduce risk of timing in these funds.
As the name suggests, these funds invest a high proportion of their assets in government securities, often long term in nature. While short-term gilt funds carry low risks, the returns are also capped. It is only the long-term gilt funds that generate capital appreciation during rate cuts.
While these funds are sovereign-backed and therefore safe in term of credit quality, the longer maturity makes this class of funds most vulnerable to interest rate cycles. Quick capital appreciation from a falling rate scenario or short-term losses in case of sharp rise in rates means that timing plays a major role in these funds.
Their volatility, therefore, makes them less suitable for retail investors, who look for debt funds to hedge their portfolio. HNIs and institutional players may take on these risks better.
Corporate bond or credit opportunity funds
These funds are relatively new to the debt universe, although as a strategy they were in practice, especially in income accrual and dynamic bond funds. Corporate bond/credit opportunity funds take exposure only to corporate bonds and do not play the interest rate game.
They gain from coupon (interest accrual) from the bond or where there is a rally in bonds (when the spread between corporate bond and government bond shrinks) they also gain from the capital appreciation. Since they depend on the coupon as a primary source of income, the bonds they take exposure to may not always be top rated but would carry higher coupon rates.
However, these could be promising companies that would possibly be upgraded. These category of funds therefore, have an element of credit risk. They need a holding period of 3-4 years, which is typically the period over which they receive the coupon income.
These funds require investors to stomach higher risks than income/dynamic bond funds but hold the promise of delivering well if the fund manager spots the right credit opportunities.
Other categories of debt include capital protection schemes and fixed maturity plans. But since these funds either have a lock in or a fixed maturity, we are not discussing them in the context of open-ended debt funds fitting various time frames.
Time frame alone not enough
When you invest in debt funds, your choice of fund should be primarily based on your time frame. But that is not enough. As discussed, some fund categories, such as dynamic bond/income accrual/corporate bond funds carry higher risks and need a longer time frame to ride the risk.
If you have a long-term time frame but are totally risk averse, then you will have to settle for short-term debt funds. Of Course, that means a possibility of capping your returns as well.
A variant of this article first appeared in FundsIndia’s monthly newsletter in 2012.