When the question of investing in less risky avenues arises, most investors swear by bank fixed deposits or securities issued by corporates or company deposits. Mutual funds offer a whole range of schemes categorised as ‘debt funds’, which offer far more flexibility and options to invest. Their objective is to generate steady returns while preserving capital, which makes them a worthy investment option for that portion of savings where safety is important.
Depending on the mandate, debt funds mainly invest in a mix of debt or fixed income securities, such as corporate bonds, money market instruments, treasury bills, government securities, and other debt securities having different time horizons. Returns generated by debt funds comprise the interest received from the underlying securities and the capital appreciation/depreciation of these securities depending on the market conditions.
How to make the most of debt funds Investments in debt funds should be guided by factors like liquidity (time-horizon), taxation and risk profile.
Liquid funds: They generally invest in very short-term papers or overnight instruments like repo, certificate of deposit and commercial paper. The objective here is to provide very high level of liquidity, which allows you to invest even for a day. So they are ideal to park your excess or contingency funds that you may need anytime. Instead of keeping the money idle, it is best to park them in liquid/ultra-short funds and withdraw when the need arises. Another way to use liquid funds is to invest the lump sum in liquid funds and make a systematic transfer into equity on a periodic basis. That way the lump sum keeps earning money and you also get the benefit of systematic investment plan.
Ultra short-term funds/short-term funds: As the name suggests, these funds invest in securities generally maturing over medium to short-term. Thus, if you have a time horizon of over one month, look at investing in ultra short-term funds. If your time horizon is at least six months, short-term funds are ideal for you. These funds typically generate higher returns compared to liquid funds.
Long-term/gilt funds: Ideal for investments with a time horizon of one year or more, long-term debt and gilt funds invest in securities, which have long maturities. The idea is to benefit from higher interest rates as well as capital appreciation. Since interest rates and prices of debt securities have an inverse relationship, these funds are an ideal investment in a falling interest rate scenario. If the interest rates in the system fall, all subsequent new securities would be issued at lower rates. The existing high interest rate securities would obviously command a premium. However, they do come with higher interim volatility and hence it is important to have a long time horizon.
FMPs: Fixed Maturity Plan is a good alternative to your traditional bank FDs if you have a known time horizon. FMPs are generally available for three years or more. They are more tax efficient compared to FDs due to their indexation benefit. Additionally, debt funds do not deduct tax at source and enjoy indexation benefit for a horizon greater than three years. But remember, FMPs are close-ended and do not offer any interim liquidity. Ensure that you have the time horizon before investing.
Important things to keep in mind while choosing a debt fund are its credit quality, expense ratio and exit load. Credit quality of the fund will tell you how risky the fund is so that you don’t end up taking on unnecessary risk. Expense ratio and exit loads can play a vital role in effective returns generated by the fund. The lower the expense ratio, the better the returns, and vice-versa.
Probably due to lack of awareness, there is apprehension among retail investors when it comes to debt fund investments. Now that you broadly know how to make the most of debt funds, go ahead and optimally make use of them for stability in your portfolio. A sound financial adviser can help you in selecting the right fund(s) for you.
The writer is CIO (debt) and head, products, at Kotak Mahindra Asset Management Co Ltd.