• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

Aarati Krishnan

THE option of converting your investment into cash any time, a low tax outgo and the possibility of higher returns — these are the key attractions of debt mutual funds.

But for the novice choosing the right kind of debt fund is akin to landing up in a favourite department store during a clearance sale. There is a bewildering array of choices and you are not quite sure what suits your purse!

Fund houses offer at least half-a-dozen versions of debt funds. Apart from the plain-vanillas, there are short-term funds, fixed-maturity plans, floaters, liquid and money-market funds, gilt funds. Which of these is the best for you? To zero in on the product that best suits your needs, you have to look at two key factors: What is your priority — safety, liquidity or returns? And what is your investment horizon?

Safety

If your foremost concern is the safety of capital, you can choose from money-market and liquid funds. Both invest in ultra-safe, very short-term debt instruments which can be liquidated at short notice.

Money-market funds usually invest in call money, T-bills and very short-term instruments. But a liquid fund may also invest in short-term debt issues from companies. Therefore, a liquid fund may have a marginally higher-risk profile and hold investments for a slightly longer period than a money market fund.

Even so, the average age of the securities in a liquid fund is usually less than three months.

Apart from these products, fund houses also offer treasury management plans, cash funds and short-term plans, all of which do a pretty good job of capital preservation. But these products usually cater to market-savvy institutional investors and have a high entry bar.

Pros and cons: In liquid and money-market funds, returns are likely to accrue steadily over the holding period, rather than in fits and starts. What is more, given the very short maturity profile of the portfolio, the risk of erosion in your investment due to interest rate movements, is negligible. There is also negligible risk of a dent to the NAV due to borrower default, as these funds usually stick to top-notch instruments.

The only flip side to an investment in such funds is that returns may be several notches lower than that available from plain-vanilla debt funds or gilt funds. For instance, since 1997, the Templeton Money Market Fund has earned an annualised return of 9.7 per cent against the 14.1 per cent notched up by Templeton's debt fund — Income Builder Account. Going forward, as interest rates stabilise, returns from money-market funds can be expected to be much lower, in the 4-5 per cent range.

Returns

If you can handle temporary blips in your fund's NAV, but seek returns that are several notches above that offered by bank fixed deposit, then the choices are: Plain-vanilla debt fund, Gilt fund and products such as fixed maturity plans — all of which invest in debt instruments with longer maturity periods. What is the difference among these?

In an ordinary debt fund (Sundaram Bond Saver, Templeton Income Builder Account, HDFC High Interest Fund, and so on), the fund manager actively mixes debt instruments from varying issuers maturing at different points in time to deliver higher returns than will be possible by passively holding a debt instrument.

A gilt fund restricts itself to debt securities issued by the government. In theory, a gilt fund should offer lower returns and carry a lower level of risk, relative to an ordinary debt fund.

This is because a gilt fund faces negligible risk of the borrower (in this case, the government) defaulting on an obligation. But, in practise, in recent times, gilt funds have offered higher returns and have been subject to greater swings in their NAV, than pure debt funds. This is mainly because gilts are more responsive to changes in interest rates than corporate bonds.

Pros and cons: Returns from debt and gilt funds may be significantly higher than what you get from your savings bank account, or even from your bank term deposit.

For instance, over the past three years, debt funds have generated returns of 11-16 per cent annually. Gilt funds, due to the greater scope for active trading, have managed between 12 and 22 per cent.

These figures may project a misleading picture of returns, as the scope for trading gains is likely to be limited, from now on (see box).

The risk with bond and gilt funds is that, over a short holding period, the NAV can be quite volatile. Bond and gilt funds may even turn in negative returns over short time periods such as a quarter.

Where the floaters fit in: Plain debt funds and gilt funds usually hold bonds carrying fixed interest rates. So, in these funds, you may lose out on the opportunity of capitalising on any change in interest rates. Floating rate bond funds help you avoid this situation.

A floater usually invests in securities whose interest rates "float" up and down with the level of interest rates prevailing in the market. If interest rates move up, a floating rate fund will automatically benefit from higher interest receipts on the securities it holds, and vice-versa. Lay investors can use floating rate funds to diversify their portfolio.

By investing a portion of your debt portfolio (say, 30 per cent) in floating rate funds, you can be sure that part of your portfolio is in a position to capitalise on any uptrend in interest rates, even if your normal debt fund does not.

Liquidity

If you are willing to go through temporary blips in the NAV of your fund, but need to be able to pull out your investment at your whim, then it will be best met by any of the open-end mutual fund debt products that are on offer — except for fixed maturity and serial plans. Most mutual fund debt products are structured as open-end funds which will mail you the redemption cheque within two days of your deciding to pull out.

But there are a couple of products for investors who want to invest in a debt fund for a fixed period. A fixed maturity plan invests only in debt instruments that mature at a particular future date and operates like a fixed deposit. You invest in the fund and hold on until the scheduled redemption date. The fund manager ensures that all the investments in the portfolio mature at the same time as the redemption date.

The advantage of such a fund is that an investor need not bother about any fluctuations in the NAV of the fund, during the period till redemption date. A serial plan is also a similar product, but with the difference that it invests in just one particular security (usually a gilt security) with the specific maturity date.

Pros and cons: Fixed maturity plans carry very low risk and approximate guaranteed return products. Returns from fixed maturity plans may be a shade higher or on a par with bank term deposits of a comparable maturity.

But, as long-term savings options, such plans may be unattractive for retail investors. Returns are likely to be of a much lower order than fixed deposits of companies and small savings schemes such as post office monthly income schemes.

Investment horizon

Finally, your investment horizon should also determine the choice of debt funds. If you plan to stay invested for over a year, choose a plain debt fund or a gilt fund.

If you plan to stay invested for three months-one year, choose a short term or medium term plan. Money-market or liquid funds are ideal, as a temporary parking ground for cash surpluses.

Things to keep in mind

Stories in this Section
Prabhat India: Accept

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line