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All that you need to know about bond funds

by Ramaswamy P
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Investors prefer safety while investing their hard-earned money. Deposits are the first choice for many of them. Features like fixed interest, fixed time period, fixed maturity date and choice of interest payment options make them the preferable option for many Indian investors.

Deposits are perceived to be safe. But they do come with their own sets of risks – like default etc. To reduce this risk, we resort to the tactics of spreading our investments across various deposits. This is a perfect example of reducing risk by diversification. Debt mutual funds exactly practise this philosophy.

What is Debt Mutual Fund?

It is a type of mutual fund that pools investor’s money and invests in debt instruments like money market securities, treasury bills, corporate bonds, government securities etc. Since they do not invest in equity, they are usually less volatile and less connected to the violent gyrations of the stock markets.

Instead of investing directly across various deposits, we entrust our money with a qualified team of investment managers to identify opportunities, invest our money and generate returns. We need not break our head with who is giving more interest or worry about the safety of the deposits – the fund manager takes care. Above all, since mutual funds pool investor’s money, the quantum of investment is usually large. And when they make a deposit – it is usually a few hundred crores in each company vs few lakhs that we as individuals would be investing. These bulk deposits usually attract a bit higher interest rate than retail deposit rates. All these benefits flow down to the investors, of course, after deduction of the fund management expenses.

In a nutshell, investing in debt fund is a convenient proposition for every investor. But investors need to understand the various types of debt funds before investing in them. Mostly they are classified based on the average duration (of maturity) of securities that they invest and the composition of these securities:

Types of Debt Funds:

  • Overnight Funds: This is a debt fund with the shortest maturity duration – 1 day. This fund is ideal for weekend parking of money or for investing for a couple of days.
  • Liquid Funds: They invest in debt instruments – mostly treasury bills and money market instruments for a maximum of 91 days. They are ideal for an investment of a few days to a couple of months.
  • Money Market Funds: They invest in debt instruments like TBills, commercial papers, certificate of deposits, corporate bonds and government securities. This category is ideal for an investment of up to six months.
  • Ultra Short Term Funds: They invest in a mix of TBills, commercial papers, corporate bonds, certificate of deposits and government securities with an average maturity of around six months. They have the liberty to invest in AAA, AA and A-rated bonds. This helps in generating bit better returns. This fund is ideal for an investment of up to a year.
  • Short Term Funds: They hold debt securities with an average maturity of 2 to 3 years. Hence they are ideal for an investment of about two years or so.
  • Medium Term Funds: These funds hold a variety of bonds with an average maturity of 4 to 5 years.
  • Long Term Bond Funds: These funds hold bonds, predominantly government securities, with an average maturity of over 10 years.
  • Corporate Bond Funds: These funds invest predominantly in corporate bonds, with a maturity of 3 to 4 years.
  • Dynamic Bond Funds: These are funds in which the fund manager has got the mandate to switch between bonds of different duration depending on the emerging bond market outlook. Hence, these funds are more actively managed than the others in the category, with an aim to generating better returns.
  • Banking & PSU Bond Funds: These funds invest predominantly in bonds issued by banks and public sector undertakings.
  • Floater Fund: These funds invest at least 65% of the assets under management in floating rate bonds which deliver a couple of percentage returns over and above the benchmark yield.
  • GILT Funds: These are debt funds that invest at least 80% of their assets in government securities.

Risks in Debt Funds

Though debt funds do not invest in stock markets, they are subject to the following risks:

  • Credit Risk: This is also known as default risk when the issuer of the bond fails to repay the principal and interest.
  • Interest Rate Risk: Since bonds are issued with fixed interest, any change in the interest rate policy of the newly issued securities can affect the demand of existing securities. Reduction in the current interest rate can push up the demand and market value of existing securities and vice versa.
  • Liquidity Risk: When a debt fund is redeemed, if the mutual fund house is not able to sell the bonds held in the portfolio, then liquidity risk is in play.

Having got an overview of all these bond funds, how do we choose the best ones:

1. It is ideal to choose the funds whose maturity profile matches the duration of our investment.

2. Though the duration may be similar between the category of funds, their portfolio composition may not. Hence it is ideal to understand this composition and then invest.

3. Events like interest rate policy of RBI, inflation data can impact the bond yield – particularly the long duration ones. Hence these investors need to have an eye on these directions before investing.

Liquid Funds, Money Market Funds and Ultra Short Term Funds are the three categories of funds that can be used by most of the investors. Other options can be useful depending on the needs of the investor.

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