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How to select best debt mutual funds for your investment needs: Part 1

October 06, 2017 by Anirudh Dar

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Mutual funds in India are becoming increasingly popular among retail investors in India over the past few years. Among the different product categories in mutual funds, equity funds have always enjoyed the maximum popularity among retail investors. However, over the past two or three years, investors are showing lot of interest in hybrid funds (like balanced funds, monthly income plans etc). Awareness of debt mutual funds among retail investors was historically quite low.

There are several reasons why debt mutual funds historically were not as popular as equity mutual funds. Firstly, investors traditionally had a risk – free, assured returns mindset for their fixed income investments. Secondly, the distribution channels of traditional fixed income products, e.g. the banks, post office, etc are much larger than that of mutual funds. Thirdly, many investors do not have a correct understanding of risk in debt fund investments. Finally, the tax advantage of debt funds versus other fixed income investments dominated the discourse on these mutual fund products. When the tax advantage was partially taken away in 2014 Budget, a perception was created that, debt funds were no longer more attractive than bank FDs and small savings schemes.

It is heartening to see a lot of investor interest in debt funds over the last 2 years or so, despite the change in taxation. Reduction in bank and post small savings schemes interest rates has forced investors to look for fixed income products which can give better returns. Rate cuts enacted by the Reserve Bank of India over the past 2 years has led to debt funds (particularly long term debt funds) to deliver much superior returns compared to traditional fixed income products (like FDs and small savings schemes) in the last 2 years or so.

While these factors may have instigated investor interest in debt funds, a comparison of different debt fund products will enable investors to understand how best debt mutual funds can meet a wide variety of investment needs, for various investment tenures, in different interest rate scenarios.

Before we discuss different types of debt funds, let us understand one important concept. The risk free rate is always the lowest rate of return. It is natural human tendency to want high rates of returns with no risk, but it is not possible. There are times when risk free returns can beat returns from assets with risks associated with it, but these are during exceptional circumstances. On average and over a period of time, assets which are subject to market risks will always give higher returns than risk free assets. Let us now discuss various types of debt funds, their characteristics and investment needs that these funds can fulfil.

Money Market Mutual Funds

Money market mutual funds invest in money market instruments like commercial papers, certificates of deposits, treasury bills etc. Due to the very short tenures of money market instruments, money market funds have very low risk and very high liquidity. It is really simple understand why money market instruments and funds have low risk and high liquidity. If you lend money to someone who promises to return the money with interest in 3 months, the risk is much lower compared to lending money to someone who will return your money in say 10 years. The liquidity is also very high if you lend the money for just 3 months as opposed to lending it for 10 years because you will get your principal amount back in a very short time compared to the other scenario.

There are two types of money market mutual funds – liquid funds and ultra-short term debt funds. Liquid funds invest in money market securities, whose residual maturities are 90 days or less. Accordingly, these funds are suitable for parking your funds for a few days up to 3 months or so. Liquid funds, as the name suggests, offer very high liquidity. There is no exit load and redemption instructions are processed (funds credited to your bank account) within 24 hours on business days. Some liquid fund schemes offer instant redemption, for transactions made through the AMC website or through their mobile application. Liquid funds historically, have given much better returns than savings bank interest.

Please see top performing liquid funds in this link

Ultra-short term debt funds invest in money market securities, whose residual maturities range from 90 days to a year. You can get better returns by parking your money in ultra-short term debt funds for 3 months up to a year compared to liquid funds.

Please see top performing ultra short term debt funds in this link

Therefore, if you do not require immediate liquidity from your investments (investment tenure of more than 3 months), then you should invest in ultra short term debt funds. Even if there is a small difference in return from liquid funds and ultra short term debt funds, you should not loose returns (profits), especially if you have a large sum of money parked in these funds. In the last one year, top performing ultra short term debt funds returns have outperformed even short term (6 month or 1 year) bank FDs.

Short term debt funds

Short term debt mutual funds invest in government bonds and non-convertible debentures (corporate bonds). The maturities of the underlying fixed income securities of short term debt funds are typically around 2 to 3 years. Due to the short maturities of the underlying securities, short term debt funds have limited interest rate risk. Interest rate risk is directly related to the maturity or duration of the fixed income securities in a debt fund portfolio; longer the maturity or duration of the fixed income security, higher is the interest rate risk and vice versa.

Since short term debt mutual funds have limited interest rate risk, the fund managers hold the bonds and debentures in their portfolios till maturity. This is also known as accrual strategy; in other words, the fund accrues the interest income from the bonds / debentures in the portfolio and the returns over the maturity period of the bonds / debentures are not affected by interest rate changes in the interim. Investors in short term debt funds, therefore, should also try to match the investment tenures with the average maturity profile of the scheme, when investing in short term debt funds. Short term debt funds historically have given higher returns than Fixed Deposits of similar tenures

You can check the returns of top performing short term debt funds here

Though short term debt funds have limited interest rate sensitivity, investors should be aware of the credit risk when investing in short term debt funds. Not all debt funds are subject to credit risks. Short term debt funds which invest only in government bond have no credit risk; these funds are also known as short term gilt funds. Even if they are subject to credit risk, the quantum of credit risk differs for scheme to scheme.

Short term debt funds which invest primarily in non-convertible debentures are known as corporate bond funds. Corporate bonds give higher yields compared to government bonds of similar maturities, but they are subject to credit risk. Investors should understand that, credit risk and yields (return on investment) are directly related. Higher the credit risk, higher is the yield. Usually fund managers try to limit credit risk by investing in high quality papers (AAA, AA etc).Some fund managers may try to capture higher yields by investing in slightly lower rated papers. These funds which invest in slightly lower rated papers are known as credit opportunities funds. You can select short term debt funds, based on the risk / return trade-off that you are comfortable with.

We will discuss the rest of the best debt mutual funds in the part II. Please click here

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.