Classification of Debt Funds

Debt funds are most misunderstood by many investors. Here is brief description of major categories of debt funds.

1. Liquid Funds

As the name suggests, these funds invest in highly liquid money market instruments like treasury bills, certificate of deposits, commercial papers and term deposits. Main objective of this fund is to provide liquidity to the investor. They invest in securities with a residual maturity of not more than 91 days. These funds are very good substitute for savings bank account if you plan to park your surplus amount.

Who Should Invest: Liquid funds are ideal for investors who have lot of money lying ideal in savings bank account and want to earn better returns than savings account.

Time Horizon: Ideally, liquid funds should be used for short investment time frame. Any investor looking to invest for a period of up to 3 months can invest in liquid funds.

    

2. Ultra Short Term Funds

These funds invests in securities with a residual maturity of not more than one year. Investors can park their surplus for few months in these funds.

Who Should Invest: If you a saving for a short term goal like a vacation or anniversary celebration then these funds are ideal for you.

Time Horizon: Any investor looking to invest for a minimum period of 3 months can invest in ultra short term funds. These funds are ideal for 3 - 12 months of investment.

    

3. Short Term Funds

These funds invest in securities with an average maturity of one year to 4.5 years. They can invest in a mix of short-term instruments like commercial paper, certificates of deposits to medium- and longer term instruments corporate debt bonds and government securities. These funds are far more stable when compared to equity funds.

Who Should Invest: These funds are suitable for conservative investors who are looking for low risk appetite.

Time Horizon: Any investor looking to invest for a period of 1 to 3 years can invest n short term funds.

   

4. Income Funds

These funds invest in corporate bonds, government bonds and money-market instruments with an average maturity of 4.5 years or more. They can invest in 2 to 3 year corporate bonds and at the same time invest in 20 year government bond. They are highly sensitive to interest rate changes. However, the interest rate sensitivity of income funds is less than gilt funds.

Who Should Invest: Investors with moderate to high risk tolerance level, looking for both income and capital appreciation in different interest rate scenarios, can invest in income funds.

Time Horizon: Although income funds give the best returns in a falling interest rate scenario, one can invest across the entire rate cycle to earn good returns from them. I would recommend to stay invested for minimum 2 years in these funds.

5. Credit Opportunities Funds

These funds invest in corporate funds and debentures of varying maturities. As the name suggests, these funds capitalize on credit ratings. Fund managers lock in a few percentage points of additional yield by investing in slightly lower rated corporate bonds. Despite the slightly lower credit rating of the bonds in the credit opportunities fund portfolio, on an average, majority of the bonds in the fund portfolios are rated AAA and AA. The average maturities of the bonds in the portfolio of credit opportunities funds are in the range of 2 – 3 years. The fund managers hold the bonds to maturity and so there is very little interest rate risk.

Who Should Invest: These funds are suitable for investors with moderate risk appetite and are looking for better returns than short term debt funds. Investors should have a medium- to long-term investment horizon.

Time Horizon: To get the best out of these funds, investor should be invested for at least 3 years to get the better returns from credit opportunities funds.

   

6. Dynamic Bond Funds

These funds invest across all classes of debt and money-market instruments. They invest across various maturities. These funds are actively managed and follow asset allocation approach. They invest in debt and equity depending on market conditions. They switch aggressively between debt and equity to take advantage of market conditions.

Who Should Invest: They are ideal for investors with moderate risk appetite and have a long term goal. Goals like 

Time Horizon:  Any investor who is looking for long term investment can invest in dynamic funds. These are most suitable for investment of 3 to 5 years.

   

7. Gilt Funds

These funds invest in government securities with varying maturities. The average maturity can vary widely as per declared objective. These funds do not have the default risk as they invest in government bonds. However, these funds are highly sensitive to interest changes. Fund manager can take call with outlook on the interest rate. The NAV's of gilt funds can be extremely volatile.

Who Should Invest: Investors with moderate to high risk tolerance level, looking for capital appreciation, can invest in Gilt Funds.

Time Horizon: Investors should ideally put money in a long-term gilt fund during a declining interest rate scenario with a time horizon of at least 18-24 months. You should invest in a short-term gilt fund for about one year. 

   

8. Fixed Maturity Plans (FMPs)

These are close ended schemes unlike above schemes which were open ended. As the name suggests, these schemes have a fixed maturity date. These funds invest in securities whose maturity date is inline with fund's maturity date. Since the bonds in the FMP portfolio are held till maturity, the returns of FMPs are very stable. Even if interest rates move up, the fund NAV is not affected. FMPs offer returns that are relatively predictable, though not guaranteed. These schemes can be purchased only during the new fund offer period.

Who Should Invest: FMPs are suitable for investors with low risk tolerance, looking for stable returns and tax advantage over an investment period of 3 years or more.

Time Horizon: Since the term for these schemes is fixed, investors can invest in long term FMPs, say, for 3-5 years to have good returns.