The range of debt funds

Find out how debt funds are categorized & understand the basic principles behind them

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The categorisation of debt funds is simpler than that of equity funds, once you understand the basic principles behind it. A debt fund investment like a bond is defined by two characteristics--its maturity and its credit rating. Maturity looks like a complex concept but if you have read and understood How Debt Funds Work, then its quite straightforward.

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There we saw how a change of interest rates could make a particular bond more or less valuable. When interest rates fall, older bonds that are locked into a higher interest rates are worth more. Conversely, when interest rates rise, older bonds that are locked into a lower interest rates are worth less.

If you think about it for a moment, this rise or fall in the value has to be proportional to how much time is left for the bond to become mature. Maturity is the date on which the bond will be redeemed and its principle amount refunded to investors. This makes perfect sense. For example, when interest rates fall, all older, higher interest bonds gain value but one which has (for example) ten years left for maturity should gain more value than one which has only one year left for maturity. After all, the ten-year one will go on paying a higher interest rate for so much longer.

Also, from this it is clear that what matters is residual maturity rather than the total lifetime of the bond. By residual maturity we mean how much time is left for the redemption date of the bond. In this sense, a twenty-year bond that was issued eighteen years ago and a freshly issued two-year bond have the same residual maturity. If other things about these two are the same then a change of interest rates should impact their value equally.

The risk and return level of a bond is determined by its residual maturity. The shorter the maturity, the more predictable, less risky and possibly less profitable a bond will be. Longer maturity bonds will show opposite characteristics. This then becomes the obvious way of classifying bonds, both in the way fund companies operate them, as well as the way in which analysts at Value Research evaluate them.

Based on their maturity, we classify debt funds into these types:

  • Up to 91 days: liquid funds
  • From 91 days to 1 year (over past 12 months): Ultra short-term funds
  • From 1 year to 4.5 years (over past 12 months):
    Short-term funds
  • Over 4.5 years or those who's maturity vary widely: Income funds

Government Securities: Besides these maturity-based classifications, there also exist a few other variations. One is that of funds which invest only in government securities. These securities, which are also called gilts, are bonds issued by the Government of India. Unlike bonds issued by companies, the chance of the Government defaulting on its loan obligation is significantly lower.

Fixed Maturity Plans: The funds described above are all open-ended funds. However, there are also closed-end debt funds that are quite popular and useful. These FMPs, as they are called, are launched on a specific date for a specific period that can range from 1 month to 5 years. Investors must enter them at the beginning and normally stay till the end. Thus, they mean lower liquidity. However, what investors give up in liquidity, they gain in a combination of predictably higher gains and lower risk that open-end debt funds cannot offer. FMPs are an excellent alternative to bank fixed deposits. They generally offer higher returns, especially because they are much more tax-efficient because FMPs are taxed as capital gains while bank FDs are just added to the investors' normal income.

Taken together, these categories offer a range of very useful choices for investors looking for fixed-income options from mutual funds.

Read the following articles to learn more about debt funds
How debt mutual funds work
Beginners guide to debt fund categories

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