How must I choose between a liquid, ultra short-term, short-term or long-term fund?
- Vighneshwar Dundur
All the funds that you have mentioned are debt funds.
When selecting such a fund, you have to decide on the investment tenure. That's because each debt fund falls into one of the above categories depending on precisely that factor. The fund manager will design his portfolio and pack it with instruments of different maturity dates, which results in it falling in a particular category. So if you have a time frame of 45 days, it will be futile to invest in a short-term debt fund.
If you want your money on call with virtually no downside risk, then opt for a liquid fund. These funds are targeted at investors who want to park their cash for about a week to a month. The portfolio will have securities with a maturity of maximum 91 days.
Go for ultra short-term funds if you wish to park your money for 1-3 months. Here the average maturity of the portfolio (over the past 18 months) would be less than a year.
If your investment span stretches up to a year, then short-term funds (including some gilt schemes) could match your horizon. Here the average maturity of the portfolio (over the past 18 months) would be between 1 and 4.5 years. In the case of a medium & long term fund, the average maturity would vary. In such a fund we suggest you invest as per the interest rate scenario to optimise returns.
One you decide on the type of fund, look at returns. The fund manager can achieve this in two ways:
Interest rate risk: When interest rates rise, bond prices fall. So if the fund manager has his portfolio stacked with lower interest rate paper, the prices of his holdings will fall resulting in a lower net asset value (NAV). On the other hand, if interest rates fall then the price of his holdings rise and so will the NAV. The longer a bond's maturity, the greater the interest rate risk. A bond fund with a longer average maturity will see its NAV react more dramatically to changes in interest rates as the prices of the underlying bonds in the portfolio increase or decline. Fund managers take calls on the interest rate direction and if it plays out well, the returns are there to see.
Credit Risk: Bonds carry the risk of default, meaning that the issuer is unable to make further interest or principal payments. They are rated by individual credit rating agencies to help describe the credit worthiness of the issuer. Higher the credit rating, lower the risk and lower the returns. Lower the credit rating, higher the risk and higher the return. So it could be that if returns are really good, he is packing his portfolio with higher risk.
The type of instruments that pack the portfolio is what determines the maturity of the portfolio:
Bond/Debenture: It is basically a loan with the promise to repay your principal on maturity and pay an interest. Technically, bonds are issued by corporates and secured against specific assets; debentures are unsecured. In India, the terms are used interchangeably; bonds are generally referred to debt instruments issued by financial institutions and the government, while debentures refer to corporate debt.
Certificate of Deposit (CD): Issued by banks to meet their lending needs. The tenure ranges from 1 month to 5 years.
Commercial Paper (CP): Issued by a corporation for meeting short-term liabilities. It is a lower cost alternative to borrowing from a bank. CPs can be issued for maturities between 15 days to 1 year.
Government Securities (G-Secs): Bonds issued by the government for varying maturities and are considered to be quite liquid and risk free.
Treasury Bills (T-Bill): Short-term securities to help the government raise money. Usually issued with 3, 6 and 9 month maturities.
Pass Through Certificate (PTC): Issued by banks as safeguards against risk. If the bank feels that it has too many risky assets to hold on to or when additional capital for lending is needed, through a PTC it transfers some of its long-term mortgaged assets onto other investors like NBFCs and mutual funds. The investors stand to earn more money for sharing the risk.
Collateralised Debt Obligation (CDO): Sophisticated tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralised because they have some type of collateral behind them. CDOs allow banks and corporations to sell off debt, which frees up more capital to invest or loan. A CDO enables the creation of multiple layers of PTCs with varying ratings, coupons and maturities. PTCs & CDOs are also referred to as Structured Obligations.