FundsIndia explains: What are debt funds?

Income funds, dynamic bond funds, ultra short funds, yields, credit downgrades…for a newbie investor (and for many seasoned ones, too!) the world of debt funds can be a confusing place.

Explaining everything there is to know about debt funds makes for a very long article, so we will take it in stages. This week, we’ll look at the types of debt funds that there are. Next week, we’ll take up how their returns come in, the kind of risks involved and taxation.

What they are
Companies borrow for various purposes – to meet working capital requirements, to fund expansion, for capital expenditure, and so on. Similarly, the government also borrows for its own spending needs. These entities issue instruments for these borrowings – bonds, debentures, treasury bills, commercial papers, certificates of deposits, and such.

These debt instruments carry a specific interest rate and maturity period (tenure). They are also called fixed income instruments. Maturities can range from a few days to a few months to a few years. In the case of government securities, it can go up to several years. Generally, short-term instruments are less risky than long-term ones for the simple reason that the uncertainties linked to a company’s fundamentals are higher over the long term.

Debt investments carry two types of risk. The first is that interest rates change over time. If interest rates move lower, new debt instruments issued will consequently have lower interest rates. But then the older instruments that are already issued still carry the old interest rate (called coupon). They however, adjust to the new interest rate scenario by way of change in their price. Thus, the bond prices traded in the market move in line with change in interest rates. This relationship is captured by what is called the ‘yield’ of the bond. We will discuss more about it in another article.

The second risk is that the borrower fails to meet payments. Companies are graded on their credit-worthiness or their ability to meet interest and principal repayment obligations on time. This grade is termed its credit rating. A high credit company is safer than a low-quality one, and will, consequently, pay a lower interest rate. While risk is higher in poor-quality company, rates are also higher as it is forced to pay a higher price in order to borrow.

Debt fund types
Debt mutual funds invest in a combination of debt securities – short or long term, corporate bonds, bank debt, gilts, high-quality papers, low quality papers, secured and unsecured bonds, and so on. There are, at all times, several instruments to invest in with varying interest rates and maturities. Debt funds actively juggle these instruments in their portfolio based on the interest rate movement to deliver returns. The type of debt fund it is depends on the average maturity of the instruments in its portfolio or then the kind of strategy it follows. The longer the maturity period is, the higher the risk, and thus higher the return.

Liquid funds hold instruments of extremely short maturities. By rule, they cannot invest in instruments whose maturities are more than 91 days. Typically, liquid funds hold instruments that mature in a matter of days. These can be commercial papers issued by companies (CP), certificate of deposits issued by banks (CD) or government treasury bills. These are collectively called money market instruments. Liquid funds also stick to instruments of the highest credit quality.

The short nature of these instruments, the high quality, and the lack of volatility in their NAV make them very safe investments. They have no exit loads and you can redeem investments very easily in these funds. For these reasons, liquid funds are the perfect alternative to savings bank accounts, which carry the lowest interest rates. Money left idling in your savings bank account, therefore, can be shifted into liquid funds to get higher returns.

Ultra short-term funds are a step above liquid funds in terms of the maturity of the instruments they hold. That is, while they hold CDs and CPs, they go for corporate or bank bonds that are a bit longer term in nature of up to one year, or maybe a little longer. Therefore, they require a holding period of around a year. Currently, the average maturity period of ultra short-term funds is around 9 months. Most ultra-short term funds invest in high-quality credit. They are good parking grounds for surplus money that you don’t need immediately but may require a little later on. They deliver higher returns than liquid funds.

Short-term debt funds go for longer maturity periods than – yes, you guessed it –ultra-short term funds. They invest in corporate bonds to a greater degree, and rely far less on CD and CPs. They may also have some holding in short-term government securities. The average maturity periods of the portfolios will typically be around 2 years or a maximum of 3 years. They require a holding period of around 2 years.

Long-term debt funds (you’re now a pro!) invest in much longer-term debt of 3 years and more. These funds require holding periods of at least three years and should form a part of every long-term investment portfolio. Think of both short-term and long-term debt funds as an alternative to your normal go-to option of fixed deposits.

Short-term and long-term debt funds may take a call to invest in instruments of low credit quality companies. Because such instruments carry attractive interest rates, the portfolio’s yield moves higher and returns jump, though the risk also moves a couple of notches higher. Funds that explicitly (by mandate) follow such a strategy of identifying companies with poor credit and high interest rates and lending to them are called credit opportunity funds and are among the highest-risk debt funds.

Some short-term and long-term debt funds are also called income funds due to their strategy. These funds hold bonds to maturity and primarily aim at earning interest income (or in finance-speak, an accrual strategy) across rate cycles. They do not try to predict or play the interest rate cycle. Such funds primarily hold corporate bonds as that’s where rates are higher and fluctuations in bond prices lower.

Gilt funds are funds that invest entirely only in government securities (or gilts, for short) and try to benefit from changes in bond prices as interest rates change. There can be both short-term and long-term gilt funds. These funds are akin to sector funds in equities – they require careful watching and timed entries and exits and are thus the highest-risk category of debt funds.

All the above are open-ended debt funds. This apart, you have close-ended debt funds called Fixed Maturity Plans, which have a fixed tenure. Your investment is locked for this period. Tenure can be a few months to a few years. They invest in money market instruments, bonds, and gilts. FMPs usually match the maturity profile of the portfolio to their mandated maturity period.

To recap, the risk and return levels from lowest to highest are in order of explanation above – liquid, ultra-short, short, long, gilt. You’re now well-versed in the categories of debt funds! Next week, we’ll look at how returns are generated for debt funds and why the risk levels are as mentioned.