Understanding Debt Funds

In Brief:

• Debt funds are generally considered to be less risky than equity funds. Debt market instruments are like bank fixed deposits, but they can be bought and sold at a price that is governed by interest rate of the instrument, demand/supply and market sentiments.
•  Debt funds are good for investors looking for capital preservation with regular income as secondary need
• Corporate and institutions invest more in debt funds than individuals
• Several investors use debt funds to generate regular income
• If used well, debt funds can be more tax efficient than Fixed Deposits
• Returns on debt funds are inversely related to interest rate movements

Debt funds are of three types:

Income or bond funds

• These invest in medium-long term instruments like corporate bonds, debentures and fixed deposits.
• These invest in treasury bills, call money, commercial papers
• Institutional investors dominate this segment

Liquid Money market Schemes

• Invests in instruments with short term period like commercial paper, treasury bills, call money and inter-corporate deposits
• Maximum retail investor money in debt funds comes in this category
• Risk comes from money market volatility – which also creates the possibility of gain due to a sudden increase in rates.

Gilt Schemes

• Invest in sovereign papers issued by the central government and the state governments
• Good for investors with least risk-tolerance and willingness to take small cut in returns
• Least popular of the three categories, with barely any retail investment

There are other plans, too, like monthly income plans (MIPs) and fixed maturity plan (FMP). In MIP every month a fixed amount is invested of which approximately 20% is allocated to equity and the remaining to debt. A fixed maturity plan (FMP) is a close-ended scheme {mutual fund equivalent of a bank fixed deposit}, and has an exit load if redeemed before the maturity period with a maturity period of three months to three years.

Risks associated with debt funds:

• Interest Rate risk – risk emerging from an adverse change in the interest rate prevalent in the market so as to affect the yield on the existing instrument.
• Credit Risk – the risk of default, i.e. the issuer is unable to make further income or principal payments.