Types of Debt Funds

Equity funds invest in shares and these investments can be held as long as possible

(based on the funds strategy). Debt funds invest in fixed income securities like bonds,

deposits etc., and these investments have fixed tenure (varying time-frames). The primary

aim of a debt fund is to generate steady returns by investing in interest paying

securities.

So, there are various types of Debt Mutual Funds that invest in various fixed income

securities of different time horizons. (Time-horizon is from Funds view-point and not

from an investors point of view.)

Liquid Funds / Money Market Funds

Where do these funds invest? These funds invest in highly liquid money

market instruments that provide easy liquidity. The period of investment in

these funds could be as short as a day. (There are several money market

instruments, including treasury bills, commercial paper, bankers

acceptances, deposits, certificates of deposit, bills of exchange etc)

What are the Expected Returns? Investment Returns from Liquid funds

can be slightly better than Savings Bank Account. Returns on these funds tend

to fluctuate less when compared with other debt funds.

Who should invest in Liquid funds? If you want to park your surplus cash

for very short-periods say 1 to 3 months, opt for these funds. Do not invest in

Liquid Funds for a longer period as these offer low single-digit returns at best.
 Examples : Axis Liquid Fund & HDFC Liquid Fund etc.,

Ultra Short-Term Funds

Where do these funds invest? These funds are also known as Liquid plus

funds or Cash / Treasury Management Funds. They generally invest in very

short term debt securities with a small portion in longer term debt

securities. (Funds investing in slightly longer duration debt securities than

Ultra short term funds are referred to as Short term funds)

Returns These funds can generate better returns than Liquid Funds.

Suitable for investors who are willing to marginally increase their risk.

When to invest in Ultra Short-term funds? If you have surplus money

which needs to be invested for say 3 to 9 months, you can consider investing

in these funds.

Examples: Axis Banking Debt Fund, IDFC Banking Debt Fund,Birla

Sunlife Short-term fund etc.,

Income Funds

Where do these funds invest? They invest a major portion in various debt

instruments such as bonds, corporate debentures, government securities and

money market instruments of various maturities and issuers. These funds can

further be classified as, Gilt Funds, Long-term Income Funds and Dynamic

Bond Funds. Gilt Funds invest in government securities of medium and long

term maturities issued by central and state governments. Dynamic Bond

Funds invest in debt securities of different maturity profiles. These funds are
 actively managed and the portfolio varies dynamically according to the

interest rate view of the fund managers.

Returns You can expect better returns on these funds when compared with

Short term or Liquid funds. But you should be ready to take higher risk. These

funds generally tend to give better returns when the interest rates have peaked

and when the interest rate cycle is in downward trend. Most of the gilt funds

or income funds have given double digit returns over the last 1 to 2 years.

Who can invest? These funds are suitable for investors who are willing to

take a relatively higher risk and have longer investment horizon (say 1 to 3

years). You can consider Gilt funds in a falling interest rate scenario. Invest

in a Dynamic Income fund if you want to gain from both rising and falling

interest rate scenarios. But, dynamic funds can have high interest rate risk

associated with it.

Examples : L&T Gilt Fund, SBI Magnum Gilt, HDFC High Interest

Dynamic Fund, IDFC Dynamic Bond Fund, TATA Dynamic Bond Fund

etc.,

Monthly Income Plans (or) Hybrid Debt Funds

Where do these funds invest? These funds invest in a mix of Debt and

Equity in the proportions of say 80:20 or 70:30 or other proportions of similar

kind. The objective of these funds is to provide enhanced regular returns to

risk-averse investors by taking small positions in equity assets. The debt

portion ensures stability, safety and consistency, while the equity instruments
 in the portfolio boost the returns. Kindly note that MIPs are market-linked

products (to the extent of their equity portfolio).

Returns Good MIPs can give you better returns than bank fixed deposits.

Infact, some of the MIPs sometimes do give double digit growth depending

on the interest rate cycle.

Who can invest? If you have a financial goal which is 2 to 3 years away

from now, you can surely consider investing in MIPs instead of investing in

bank FDs or RDs.

Examples : Kindly read Best Mutual Fund Monthly Income Plans.

Below are some of the other forms of Hybrid Debt funds.

Capital Protection Funds: Capital Protection Funds (CPFs) are close-ended

schemes. These funds invest in debt instruments in such a way that at the end of the

term (tenure) of CPFs, the value of debt investment is equal to the original

investment in the fund. The equity portion aims to add to the returns of CPFs at

maturity. Do note that these funds are oriented towards protection of capital and do

not offer guaranteed returns. These funds are rated by Credit Rating Agencies like

CRISIL / ICRA.

Fixed Maturity Plans : These are also close-ended schemes and are similar to

CPFs. These funds have fixed tenure like 400 days, 1000 days etc., Units of these

close-ended funds can be purchased only during the New Fund Offer period and

cannot be redeemed during the tenure of such funds. To provide liquidity to

 investors, FMPs are also listed on Stock Exchanges. If you are looking to park your

money for a fixed tenure during uncertain interest rate movements, FMP is the

answer.

Risk Vs Return of various Debt Funds

As discussed above, the longer the maturity of the fixed income securities, the

higher the interest rates risk. Accordingly, risk-reward relationship can be

represented as below;

Debt Funds & Tax Implications

From taxation point of view, MF schemes that invest at least 65% of its fund corpus into

equity and equity related instruments are treated as Equity Funds.

Mutual Fund Schemes that hold less than 65% of their portfolio in equities and

equity related instruments are treated as Debt Fund (Non-Equity Funds).

 Long Term Capital Gains (LTCG) If you make a gain / profit on your

investment in a Non-Equity Mutual Fund scheme (or in a Debt Fund) that you have

held for over 3 years, it will be classified as Long Term Capital Gain. The LTCG

tax rate on Debt Funds is 20% (with indexation benefit).

Short Term Capital Gains (STCG) If you make a gain / profit on your Debt fund

(or other than equity oriented schemes) that you have held for less than 36 months

(3 years), it will be treated as Short Term Capital Gain. The gains are taxed as per

your Income Tax Slab rate. (You may like reading Mutual Funds & Tax

implications)

My Opinion (Debt Mutual Funds Vs Bank Fixed Deposits)

Debt Mutual Funds offer several benefits. But most of the small investors know little

about them and prefer to invest in Fixed Deposits or Recurring Deposits. So, lets

compare debt mutual funds with bank deposits.

TDS is applicable on Bank FDs/RDs, if your interest income exceeds Rs 10,000 a

year. The other issue is that the interest income is taxed on annual basis. TDS is not

applicable on Debt fund redemptions. Also, the tax is deferred indefinitely till you

redeem your Debt fund units.

One more advantage with debt funds is that the gains from a Debt Fund can be set

off against Short-term & Long-term capital losses (if any) from your other

investments.
 If you have lump sum money to be invested in Equity oriented Fund, you can opt

for STP (Systematic Transfer Plan) from a Liquid Debt fund to an Equity fund of

your choice (within same AMC).

Debt Funds can give better returns than your Savings Bank Account & Bank

deposits.

Safety of capital is almost the same with both the options (Debt MFs & FDs). FDs

may offer you assured returns but Debt funds can offer you higher post-tax returns.

(You may like reading Why you should avoid investing in Bank FDs/RDs for

longer periods)

If you are in 20-30 per cent tax bracket, tax-efficient debt funds can be more

beneficial to you than FDs.

Investors generally compare debt funds past returns with FD or Bank interest rates.

But, Debt Fund returns should be compared to FD rates that were prevailing at the

start of the period of comparison.

Debt Funds can also be considered for investment during your Retirement phase for

Systematic Withdrawals.

Debt Funds are as liquid as your Bank deposits. However, some funds can levy Exit

Load for exiting before the minimum holding period. Even a 0.5% to 1% exit load

can shave off a significant portion from your gains. So, have an eye on exit load.

If you have any financial goal(s) which is less than 5 years away, which can be met with
8% to 10% rate of return (or) when you are not comfortable with high volatility
(risk) then you can surely consider investing in Debt Funds.