Debt funds can be categorized on the basis of the type of debt securities they invest in. The distinction can be primarily on the basis of the tenor of the securities—short term or long term, and the issuer: government, corporate, PSUs and others. The risk and return of the securities will vary based on the tenor and issuer. The strategy adopted by the fund manager to create and manage the portfolio can also be a factor for categorizing debt funds.
On the basis of Issuer
Gilt funds invest in only treasury bills and government securities, which do not have a credit risk (i.e. the risk that the issuer of the security defaults). These securities pay a lower coupon or interest to reflect the low risk of default associated with them. Long-term gilt funds invest in government securities of medium and long-term maturities. There is no risk of default and liquidity is considerably higher in case of government securities. However, prices of long-term government securities are very sensitive to interest rate changes.
Corporate bond funds invest in debt securities issued by companies, including PSUs. There is a credit risk associated with the issuer that is denoted by the credit rating assigned to the security. Such bonds pay a higher coupon income to compensate for the credit risk associated with them. The price of corporate bonds are also sensitive to interest rate changes depending upon the tenor of the securities held.
On the basis of Tenor
Liquid schemes or money market schemes are a variant of debt schemes that invest only in short term debt securities. They can invest in debt securities of upto 91 days maturity. However, securities in the portfolio having maturity of more than 60-days need to be valued at market prices [“marked to market” (MTM)]. Since MTM contributes to volatility of NAV, fund managers of liquid schemes prefer to keep most of their portfolio in debt securities of less than 60-day maturity. As will be seen later in this workbook, this helps in positioning liquid schemes as the lowest in price risk among all kinds of mutual fund schemes. Therefore, these schemes are ideal for investors seeking high liquidity with safety of capital.
Short term debt schemes invest in securities with short tenors that have low interest rate risk of significant changes in the value of the securities. Ultra-short term debt funds, short-term debt funds, short-term gilt funds are some of the funds in this category. The contribution of interest income and the gain/loss in the value of the securities and the volatility in the returns from the fund will vary depending upon the tenor of the securities included in the portfolio.
Ultra short-term plans are also known as treasury management funds, or cash management funds. They invest in money market and other short term securities of maturity upto 365 days. The objective is to generate a steady return, mostly coming from accrual of interest income, with minimal NAV volatility.
Short Term Plans combines short term debt securities with a small allocation to longer term debt securities. Short term plans earn interest from short term securities and interest and capital gains from long term securities. Fund managers take a call on the exposure to long term securities based on their view for interest rate movements. If interest rates are expected to go down, these funds increase their exposure to long term securities to benefit from the resultant increase in prices. The volatility in returns will depend upon the extent of long-term debt securities in the portfolio.
Long-term debt schemes such as Gilt funds and Income funds invest in longer-term securities issued by the government and other corporate issuers. The returns from these schemes are significantly impacted by changes in the value of the securities and therefore see greater volatility in the returns.
On the basis of Investment Strategy
Diversified debt funds or Income fund, invest in a mix of government and non-government debt securities such as corporate bonds, debentures and commercial paper. The corporate bonds earn higher coupon income on account of the credit risks associated with them. The government securities are held to meet liquidity needs and to exploit opportunities to capital gains arising from interest rate movements.
Junk bond schemes or high yield bond schemes invest in securities that have a lower credit rating indicating poor credit quality. Such schemes operate on the premise that the attractive returns offered by the investee companies makes up for the losses arising out of a few companies defaulting.
Dynamic debt funds are flexible in terms of the type of debt securities held and their tenors. They do not focus on long or short term securities or any particular category of issuer but look for opportunities to earn income and capital gains across segments of the debt market. Duration of these portfolios are not fixed, but are dynamically managed. If the manager believes that interest rates could move up, the duration of the portfolio is reduced and vice versa.
Fixed maturity plans are a kind of debt fund where the duration of the investment portfolio is closely aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-identified investments. Further, being close-ended schemes, they do not accept money post-NFO, therefore, the fund manager has little ongoing role in deciding on the investment options.
Floating rate funds invest largely in floating rate debt securities i.e. debt securities where the interest rate payable by the issuer changes in line with the market. For example, a debt security where interest payable is described as ‘5-year Government Security yield plus 1 percent’, will pay interest rate of 7 percent, when the 5-year Government Security yield is 6 percent; if 5-year Government Security yield goes down to 3 percent, then only 4 percent interest will be payable on that debt security. The NAVs of such schemes fluctuate lesser than other debt funds that invest more in debt securities offering a fixed rate of interest.
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