Debt Mutual Funds For Risk Averse Investors

Are you looking for debt instruments beyond bank fixed deposits and post office instruments? Debt mutual funds may well be the place to be. Not only are you assured of liquidity but it may also offer you higher returns than the traditional debt products. 

What is a debt mutual fund?

Debt mutual fund is a product for investors whose main aim is capital preservation coupled with descent returns i.e. higher than savings account and bank fixed deposits. They invest primarily in fixed income instruments.

Debt fund returns is governed by movement in interest rates. Prices of debt securities and interest rates are inversely related and hence any change in interest rate will have an impact on the NAV of the fund in the opposite direction. Debt fund returns is essentially a combination capital appreciation and regular income.

Capital appreciation: This is where a debt mutual fund has an edge over a fixed deposit. Capital appreciation is possible because the debt instruments that the mutual fund company invests in are tradable. Based on the interest rate, the bond yields move. When interest rates move southwards, yields on bonds increase making it profitable for mutual fund companies to sell the bond.

Regular/Timely income: Given that debt mutual funds invest in fixed income instruments, the interest income earned, is passed on to the investors in the form of dividend. The quantum of dividend will be dependent on the tenure of the fund i.e. whether it is a short term or long term fund

There is a gamut of debut mutual funds in the market. They include

Money market Mutual funds (MMMFs)

MMMF is a product that invests primarily in short term instruments maturing in a year or less. They include instruments such as Treasury Bills (TBs), Commercial Papers (CPs) and Certificate of Deposit (CD).

• TBs are government securities having tenure of not more than one year. They are considered as risk free instruments because they are issued by the government.
• CP is issued by companies looking to meet their short term financing needs the tenure of which can be anywhere between 15 days and 1 year.
• CD is a short term debt instrument issued by a bank.

This product primarily invests in some of the most secure investment products and hence the risk element is very low. Hence this is suited for risk averse investors looking for short term investment opportunities. Some of the funds include Templeton India Money Market Account fund, UTI Money Market Mutual fund among others.

Liquid funds

Liquid funds are an investment product used to park surplus funds for a short period of time such as 1-3 months. It is an alternative to short term fixed deposits. This fund invests primarily in low maturity money market instruments and the call money market. The objective is to provide income with very high liquidity. The interest rate risk in liquid fund is very low because the instruments in which they invest are very short term and are typically held till maturity. Some of these funds include ICICI Prudential Liquid fund, DSPBR Liquid, Bharti Axa liquid among others.

Gilt Funds

These funds invest exclusively in government securities know as G-secs. These are instruments issued by the Central and State Government having medium to long term maturity. By virtue of them being a sovereign security, they are assigned the highest credit rating and hence carry minimal risk. It is advantageous to invest in a medium/long term gilt fund when the interest rates are about to fall and in short term gilt fund when the interest rates are on the rise. These funds are exposed to interest rate risk as is the case with any debt fund. Some of these funds include HDFC Gilt fund, JM Gsec Regular plan, BOB Gilt fund among others.

Income Funds

They primarily include short term and medium term funds

• Short Term Income Fund

These funds invest in short term money market instruments and corporate bonds (high grade) with maturities not exceeding more than 3 years. The objective of this fund is to provide high current income without compromising on liquidity. Investors having a short term horizon can invest in these funds. E.g. Templeton India Short term income plan, HSBC Income Short term among others.

• Medium Term Income Fund

These funds invest in medium term money market instruments and corporate bonds which are of a high grade. The objective is to provide higher returns than short term funds with liquidity. Investors with a medium term horizon i.e. greater than months can opt for this fund. E.g. DWS Premier Bond fund, HDFC High interest, and ICICI Prudential Medium term among others.

Floating rate funds

As is indicative from its name, floating rate funds invest in debt instruments having a floating interest rate. The interest rate will move in tandem with the interest rate in the economy. There are 3 types of floating rate funds which include short term, medium term and long term. Depending on the investment horizon, investors should select a plan accordingly. This fund is best invested in, when the interest rates in the economy are on the rise. Some of these funds include Birla Floating Rate LTP, Pru ICICI Floating Rate among others.

Fixed Maturity Plans

These are close ended funds having a fixed duration i.e. maturity. There is a subscription period within which investors should subscribe for units of the scheme after which the scheme is closed for further subscriptions. They have varied maturities from as low as 6 months – 3 years. On the maturity date, units of the investors are bough back by the mutual fund company on the NAV of that day. The objective is to provide a fixed income, for a fixed period, by investing in various debt instruments. Examples include Axis Mutual Fund FMP- Fixed Term Plan Series 2 (371 days), Tata Fixed Maturity Plan Series 25 – Scheme C – Retail Investment Plan among others.

Tax Treatment

• Dividend income: This is tax free in the hands of the investor. However, a dividend distribution tax is paid by the mutual fund company when it pays dividend.

• Capital Gains: Long term investments i.e. investment held for more than a year is taxed at a lower rate of 10% without benefit of indexation or 20% with the benefit of indexation. Short term gains are taxed at 15%.