Debt funds are mutual fund schemes which invest in debt and money market securities. There are different types of debt mutual funds which can cater to large spectrum of investment tenures and risk appetites. There are three broad categories of debt mutual funds and within each there can be quite a few sub-categories.
Money Market Mutual Funds
Money market mutual funds invest in money market instruments like commercial papers, certificates of deposits, treasury bills etc. Money market instruments usually have very short maturity periods (less than a year). The two important characteristics of money market mutual funds are high liquidity and low risk. There are two types of money market mutual funds – liquid funds and ultra short term debt funds.
Liquid funds invest in money market instruments whose residual maturities are less than 3 months. These funds have no exit loads which imply that they can be redeemed at any time without penalty charges. Redemptions in liquid funds are processed within 24 hours on business days. Some liquid fund schemes also offer instant redemption (within a few minutes) for transactions made through AMC websites or mobile apps. Liquid funds can be used to park funds for a few days to few weeks to few months. They give significantly higher returns than savings bank interest.
Ultra-short term debt mutual funds invest in money market instruments whose residual maturities range from 3 months to a year. Many ultra-short term debt mutual funds have no exit loads, but some schemes levy exit loads for redemptions made within a specified period (usually a few days) from the investment date. Ultra-short term debt mutual funds usually give higher returns than liquid funds and so, if you do not need immediate liquidity (say within 3 months or so from the investment date), you should invest in ultra-short term debt mutual funds.
Short term debt funds
Short term debt mutual funds invest in Government securities and corporate bonds (usually called non-convertible debentures in India). This type of debt mutual fund schemes invests in securities which mature in 2 to 3 years, hence the name short term debt mutual funds. The interest rate sensitivity of these funds is quite limited, due to the short maturity periods. The main investment objective of short term debt mutual funds is income accrual; the fund managers hold the securities in their portfolio to maturity to earn the income (interest) from them. There can be different types of short term debt mutual funds, depending on the kind of securities they invest in.
Short term gilt funds invest Government securities (also known as gilts) maturing in 2 to 3 years. There is no credit risk in Government bonds. Corporate bond funds invest primarily in non convertible debentures issued by private sector and public sector companies. Corporate bonds may have some credit risk, but their yields are higher than gilts of similar maturities. A type of corporate bond funds, known as credit opportunities funds, invests in with slightly lower quality (credit rating) corporate paper. Slightly lower papers give significantly higher yields compared to AAA or AA rated papers. Some short term debt mutual funds can invest in both Government bonds and non convertible debentures.
You can invest in short term debt mutual funds, if you have a 2 to 3 years investment horizon. These mutual fund schemes can give superior returns compared to fixed deposits and small savings schemes. If you are investing in corporate bonds, you should check the credit risk of the underlying corporate bonds at a portfolio level to make sure that you are comfortable with the risk.
Long term debt funds
Long term debt mutual funds invest in securities with long maturity profiles. Since yield curve is generally upward sloping bonds with longer maturities give higher yields than bonds with shorter maturities. But longer maturity bonds are subject to interest rate risk. Interest rate risk can work both ways. If interest rate goes up, the price of long maturity bonds and the NAVs of long term debt mutual funds fall. If interest rate falls, the price of long maturity bond and the NAVs of long term debt mutual funds rises. You should have a long investment horizon of three years or more for long term debt mutual funds, because over a long investment horizon, there are periods of both rising and falling rates and their opposing effects cancel out each other.
There can be different types of long term debt mutual funds depending on the nature of underlying securities and investment strategies. Long term Gilt mutual funds invest in long maturity Government bonds. These funds are highly sensitive to interest rate changes. Income funds can invest in both Government bonds and NCDs. Long term debt mutual funds aim to benefit primarily from duration calls (profiting from interest rate changes) and also income accrual. Strategic bond funds employ a flexible strategy depending on the interest rate environments.
Long term debt mutual funds are good investment options for investors who are ready to remain invested for three years or more. They can give both income and capital appreciation to investors. Investors can also benefit from the long term capital gains tax advantage of debt mutual funds, if they remain invested for more than three years. Long term capital gains in debt mutual funds are taxed at 20% after allowing for indexation benefits. The tax advantage of debt mutual funds make them attractive investment options compared to traditional fixed income schemes.