Investing in credit opportunities mutual funds? Know the risks first

Source: The Economic Times

Several funds in the category have clocked more than 10% return over the past one year.

With the central bank signaling a neutral interest rate stance in its latest monetary policy review, the rally in gilt funds has petered out. They have been knocked off their perch by credit opportunities funds, which have emerged the top performers in the debt funds space over the past one year. The category generated an average return of 9.6%.

Gilt funds and credit opportunities funds play on different aspects of the bond market. The former invest in longer maturity government securities that witness high capital appreciation in a softening interest rate environment. The latter focus on interest accrual— the income from coupon payments on underlying bonds—and typically invest in corporate bonds with a higher yield but lower rating (AA or below).

Credit funds can also make some returns from capital gains, by looking for mismatches in the current rating of a bond vis-a-vis its fundamentals. If the credit rating of the underlying bond gets upgraded, due to the improving fundamentals of the underlying company, it results in appreciation in the bond’s market price, boosting the fund’s return. However, this tends to account for a smaller portion of the total return from these funds.

The cost of higher returns

With the interest rate easing all but over, the performance driver for debt funds has shifted from bond price appreciation to income accrual. Besides, what has worked in favour of credit funds is the lower volatility in returns, compared to gilt funds.

Several funds in the category have clocked more than 10% return over the past one year. However, they have taken greater risk to generate these returns, as is indicated by their exposure to lower-rated instruments (see table). BOI AXA Corporate Credit Spectrum and Franklin India Dynamic Accrual have invested 45% and 51% of their portfolio, respectively, in bonds rated ‘A and below’.

HIGHER RETURN, MUCH HIGHER RISK

In a bid to generate higher returns, several credit funds have increased exposure to lower rated bonds. 

Source: Value Research. Data as on 4 Sep 2017

The category’s average exposure to this segment is around 31%. But while BOI AXA has also taken a healthy exposure of 22% in high safety AAA-rated bonds, Franklin India Dynamic has negligible investment in this segment. AAA rating indicates highest level of safety (little risk of default), while A and lower rating signifies a much higher default risk.

Baroda Pioneer Credit Opportunities has loaded up on relatively safer AA rated instruments, comprising 56% of its portfolio, compared to the category average of 50%. Meanwhile, Aditya Birla Sun Life Corporate Bond holds around 40% of its portfolio in AAA-rated instruments—peers’ holdings in the segment is just about 20%.

Why credit quality is a concern

The composition of the underlying portfolio of credit funds assumes great significance in the light of numerous instances of corporate loan defaults and credit rating downgrades. When underlying bonds witness rating downgrade, their price falls sharply, eroding the overall return from the debt fund. Companies may face ratings downgrade owing to deteriorating fundamentals—usually high debt levels and limited traction in cash flows.

Recently, companies such as IDBI Bank and Reliance Communications have seen ratings downgrades. With the credit profile of debt- riddled firms remaining weak, credit funds, in their bid to deliver high returns, are playing a high-risk game. “Many credit funds are now carrying higher credit risk than they started with or intended to carry a few years ago,” says Roopali Prabhu, Head, Investment Products, Sanctum Wealth.

The corporate credit upgrade downgrade ratio remains unfavourable. The terms and conditions governing these bonds have become more complex. And the liquidity position in these funds remains untested in the event of redemption pressure, Prabhu adds. Although credit opportunities funds are mostly immune to unfavourable yield movement, the risk of default in underlying companies continues to be high.

“Unlike in other categories, like dynamic bond funds, the risk is far less visible in credit opportunities funds. In the event of a default, the hit may be significant,” cautions Vidya Bala, Head, Mutual Fund Research, FundsIndia. Investors should not get swayed by the higher returns being offered by this segment.

Lack of opportunity in traditional debt funds that play on interest rate movements does not warrant a complete switch to the credit funds. If you wish to play the credit risk, avoid going for the overly aggressive funds that chase higher yields with concentrated exposure in very low rated instruments. “If already invested in credit funds, rebalance in favour of cleaner credit at this juncture,” says Prabhu.

Tax Reckoner for Investments in Mutual Fund Schemes: FY 2016-2017

Source: HDFC Mutual Fund

Monthly Income Plans (MIP) of Mutual Funds

Source: Money Control

There are Monthly Income Plans (MIP) that are offered by mutual funds but often just recognising a fund by name might not do proper justice to its features. This can happen because when one goes into detail about the MIP portfolio then there is going to be a huge difference that is witnessed. The significance of this entire position is that it can change the manner in which a fund operates and the kind of returns and risk that it poses for its investors. This variation can turn out to be a shock for many investors and hence here is a look at how the nature of the MIP is more important than anything else.

Nature of fund

A MIP is a scheme where the vast majority of the portfolio of the fund is in debt oriented instruments with a small amount of equity holdings. The reason the fund is called a monthly income plan is because it seeks to provide a regular cash flow for its investors. This is the important part as there is no guarantee about the flow from the fund but it will try to provide this kind of flow and this to a large part depends upon the portfolio of the fund. With an increase in the choice for investors there is a big difference in the nature of the MIP funds that are present in the market and there is a need to segregate them into different categories.

Conservative MIP

There will be some MIP schemes that have a very low amount of equity exposure. This would fall even below the 10 per cent mark and stay at around 7-8 per cent. Here the equity part is very small and the impact that this can have on the overall performance of the fund is slightly lower. The nature of the equity holdings will also determine the way it influences the net asset value of the fund. There can be some funds where the figure for a short period can dip below but this would not make them come into the conservative category but if the average consistently remains in this range then it would mean a lower risk for the investor.

Average or normal MIP

The normal MIP would have an average equity holding in the range of 12-14 per cent and this would remain in this range over an extended period of time. The ability of the equity portfolio to influence the net asset value remains high as the debt movements can easily be cancelled out and dominated over by the equity part. This is the way in which traditionally the MIP was constructed and today too, a lot of the funds would be found to be in this category with this kind of exposure.

High risk MIP

There are also funds where the average equity exposure in the portfolio remains above the 20 per cent mark. These are a category of funds by themselves because they bring to the table a different kind of risk. The going can be good when times are fine in the equity market but a sharp plunge there can reverse the situation to such an extent that it could be a long time period for which the fund is unable to generate a regular payout for the investors. Anyone who is even thinking of a regular and steady return from their MIP should stay away from such funds as they are at one extreme of the risk scale. It would be better to be able to know the kind of risk that is being taken when the investment is made in a particular type of MIP.

Choosing between Dividend and Growth option in Mutual Funds

Source: Business Standard

Several equity mutual funds have recently announced dividend payouts. But should investors look at the dividend paying track record of a mutual fund before investing? No, say experts, because there is no real gain in the case of equity funds because the net asset value (NAV) will fall to that extent. In case of debt funds, investors will have to pay high dividend distribution tax (DDT), as much as 28.84 per cent.

According to the Value Research website, fund houses such as Birla Sunlife, BNP Paribas, ICICI Prudential, Canara Robeco, and IDFC are set to announce dividends shortly in their equity schemes. “Dividends are typically announced in bullish market when fund managers find it hard to deploy the money raised because they feel valuations are too high. They cannot keep money idle while waiting for more realistic valuations. So, they book profit and declare huge dividends,” says Tanwir Alam, founder and managing director, Fincart, a financial planning and advisory firm.

From a fund’s perspective, an equity fund’s strength lies in deploying the gains meaningfully in newer equity opportunities and not in just distributing them, points out Vidya Bala, head, mutual fund research, Fundsindia.com. That is why the dividend paying track record is not of much relevance, especially in equity funds, despite dividends not being taxed. “Equity funds are meant for long term. From an investor's perspective, equity funds are for building wealth and that cannot happen with dividend unless they redeploy the money to help compounding,” she says. That is why in equity funds, it is better to take the growth option. Similarly, in debt funds too, unless an investor is looking for some kind of regular payout or likes to keep exposure limited, one need not pay too much attention to dividend payouts.

“For investors, dividend is not a big gain because the payout is made from their own money. That is why after the dividend is announced, the net asset value (NAV) of the fund falls,” says Alam. It is only in case of arbitrage, income or liquid funds where the certainty of dividend makes sense.

“Dividend makes sense in case of arbitrage funds (treated as equity and therefore no DDT) and the recently seen equity savings funds (that use a combination of equity, debt and derivatives) where dividend is not taxed. Also, with sector funds, where investors have the risk of market timing, it may be a good idea to take some profits off the table occasionally,” Bala says.

Shankaran Naren, chief investment officer, ICICI Prudential Asset Management Company, feels dividends are a good way of returning profits to investors and hence, are attractive. “Equity is a volatile asset class. So, dividends are a good way of taking some profits and returning that to investors,” he says. Since the taxation is high in case of debt funds, if you are in the 10-20 per cent tax bracket, then it makes little sense to pay such a high DDT. “If you are looking for regular income, then it is better to use a systematic withdrawal plan (SWP), using the growth option. Over a three-year period, SWP is a better option as you can get capital gains indexation benefit,” Bala adds.

Redeeming Mutual Funds? : Know the Exit Load

Many Mutual funds charge exit loads when you want to redeem or sell your investment before some predefined interval. For example for HDFC Equity fund Exit Load is 1% for redemption within 365 days. What does exit Load? How is it calculated? What else does not have to take care of before redeeming(selling) Mutual Fund

What is Exit Load in Mutual Funds?
An Exit Load is the fee charged by Mutual Funds if an investor wishes to withdraw his investment in Mutual Fund within a specified period from that fund. This charge is calculated as a percentage of the NAV and not on the amount you invest. Time period for calculation of exit load is for every purchase or investment. Many mutual fund schemes which do not charge an exit load.

Does exit Load apply for SIP also?
The same rules govern the Systematic Investment Plan (SIP) model. In SIP, each instalment is taken as a new investment and, hence, you will be charged an exit load for it if you sell each instalment within the predefined time.

Why are Exit Load charged?
They act as a deterrent to quick withdrawals that could put pressure on fund managers to generate cash to meet the redemption. After the predefined period most equity funds have zero exit load.

How is Exit Load Calculated?
Exit Load is deducted from the NAV. For example, If an investor is redeems 10 units with NAV of Rs 10 and the exit load specified is 1% if sold within an year. Then if he sells within the year selling price per unit will be Rs 9.9. It means that the amount of money that he will get is Rs 9.9 X 10 units or Rs 99.

Let’s see with another example. Assume you invest Rs. 10,000 on the 1st of January 2014 in a mutual fund with NAV of Rs 100 that charges an exit load of 1% for redemption within 1 year. In March you invest Rs. 5250 at NAV of Rs 105 more in the same fund. How much would the exit load be if you opt to redeem in November 2014 when it’s NAV is Rs 110? How much would the exit load be if you opt to redeem in February 2015 when it’s NAV is Rs 112?

·         Number of units you bought in Jan 2014 are : Rs 10,000/100 = 100

·         Number of units you bought in Mar 2014 are : Rs 5250/105 = 50

If you redeem in Nov 2014 you would may exit load for both the investments i,e for one in : In Nov when NAV is 110, you would pay 1% of (100 * 110 + 50 * 110) = Rs. 165. You’ll get back Rs. 16335(minus STT of 0.001% if this is an equity fund)

If you opt to redeem in February of 2015? Since the first investment is past the 1 year mark. So you’ll pay not pay exit load for it. Exit load is to be paid for second investment only i.e 1% of 50 * 112 = Rs. 56. (And you’ll still pay STT on the whole amount, for equity funds).

Does every Mutual Fund have same exit load?
These loads (entry/exit) vary from scheme to scheme, but have to be within the limit prescribed by the market regulator, the Securities and Exchange Board of India (Sebi).

Is Exit Load different from Expense Ratio?
Mutual Fund companies charge investors for professional fund management and regular operational costs. It is an annual charge as percentage of the net assets of the fund and is called as Expense ratio or total expense ratio (TER). Expense ratio includes investment management and advisory fees, sales or agent commissions and service fees, legal and audit fees, registrar and transfer agent fees, fund administration expenses, and marketing and selling expenses. This is the AMC’s main source of income; it pays its fund manager’s salaries out of this portion. So yes Exit Load is different from Expense Ratio.

Equity funds can charge a maximum of about 3% of the net assets. Debt funds can charge a maximum of 2.75% of the net assets. Usually as the size of the mutual fund grows costs tend to go down. Earlier, AMC used to get a maximum of 1.25%. But in 2012, Sebi allowed fungibility of costs i.e of the 3% charge it gets to spend this money in any which way it wants.

Are there any other charges charged by Mutual Funds?
Entry load: It is a front-end charge deducted from the NAV at the time of investing in a mutual fund scheme. SEBI abolished entry loads in August 2009. These charges were around 2.25% for equity funds before abolition.

Transaction charge: Starting August 2011, SEBI has allowed Mutual Funds to collect a nominal amount as a one-time transaction fee. For the first time investor, Mutual Funds can collect Rs 150 as a fee if the investment is more than Rs 10,000 while the fee for an existing investor would be Rs. 100. For any amount less than Rs. 10,000 no fee will be charged. In the case of Systematic Investment Plans (SIPs), where the total commitment towards the SIP is more than Rs. Rs 10,000, a transaction charge of Rs. 100 will be levied payable in four equal instalments starting from the second to the fifth instalment.

Why should one worry about Exit Load?
When you sell or redeem your Mutual Funds within the time frame for which exit load is defined you will have to pay Exit Load. Hence you will get less amount back in your hands. It might seem small but if you are getting 1 lakh after redemption then exit load of 1% will take away 1000 Rs.

How does one find about these charges?
Information about these charges for mutual funds are easily available. I check the Fees & Detail section on Value researchonline.

Ten Rules for young equity mutual fund investors

Source: The Economic Times.

At 22, Aarti earns Rs 15,000. Spends a lot on music and movies. And every Saturday evening her expenses are anywhere close to Rs 300-500. Her expenses are increasing and she is slightly bothered. A friend told her to invest into equity markets through mutual funds. A call centre employee into airline ticketing, this was strange for her. She sat with her friend one afternoon and realised that there was an opportunity that she never wanted to miss. Her friend told her that if she was investing Rs 1000 in the Nifty Fifty every month for the last 10 years she would be investing Rs 1.20 lakh in total. If she decided to exit out of this investment, she would be making Rs 3.16 lakh. That is a return of 19% per annum through a systematic investment plan in the index for the last 10 years. The annual growth of the index during the same period was 13% per annum. Her friend gave her 10 rules to manager her wealth through investments in equity markets.
Ten Rules for young equity mutual fund investors
1 Young investors who are in their twenties are in the best position to invest into equities through mutual funds. The rule of 100 will gives the best answers. Basically 100 less your age give the proportion of investments that can be done into equities and the rest in debt. So if your age is 25, then 75% of your total investment will get into equity and 25% in debt.
2 Maximum proportion of the disposable income should be allocated to equities. Disposable income is the net pay less fixed expenses like loan payments and household expenses.
3 Investors can follow the systematic investment plan on a monthly basis in diversified equity funds. This will put a discipline for investors to invest every month. Ideally, a fund with the biggest corpus should be chosen. There are some funds that are allowing investors to put money to the extent of Rs 50-100 so that all type of investors can enter the funds through the SIP basis. Over the last ten years, the Index has returned 13% per annum and against this the SIP investment has returned 19% per annum.
4 Young investors are in a position to be very long term investors where they can invest into equity funds and wait for years till returns accumulate. Assuming that the investment began at the age of 25, the investor can stay invested for 35 years assuming that he works till 60 and withdraws all his investment at the same time.
5 Young investor in their twenties can take the maximum risks. They can invest into sector specific funds and Midcap funds.
6 Young investors are also in a position to invest into commodities. Commodities face the longest cycles which are basically in the range of 7-15 year. The super-cycles in commodities are in the range of 50-60 years. Only the young are in the position to take advantage of this long term cycle. As of now there are no commodity related funds in the country so retail investors will have to invest into commodities directly and this is not a good idea. In such a case investors can buy mutual funds that have huge exposure to commodities related companies than invest into commodities directly.
7 Young investors should take care of not confusing insurance with returns. The objective of insurance is completely different than equities. Ideally, unit linked investment plans (ULIP) should be not be considered as objects for maximising wealth. For that a pure equity related fund is the best tool. The cost for premature withdrawal is very high in ULIPs and investor takes the higher risk of underperformance from the insurer. The surrender value for ULIPs is lower in the initial years of investment.
8 Within equity funds, young investors can either do their own research or stay with actively managed funds or they can go for index funds. Passive or index funds would be good for investors who do not have the time and inclination to search for the best performing funds. These investors would be satisfied with market returns.
9 Investors should prefer existing schemes with a track record or performance for at least five years than in a new fund offer. This is because an investor investing for a very long term should be sure that there is a history to the fund.
10 Investors should not go by names of star fund managers but rather prefer sound investment philosophies. Fund managers leave but philosophies remain.

Step by Step: Take a SIP and stay invested

Source: The Economic Times.

One of the best ways to invest in the equity market is through the systematic investment plan (SIP) route. This enables investors to take the benefit of averaging out their cost of investment. There have been several developments recently due to which the minimum amount of investment in SIPs has fallen. While investing in SIPs, a certain sum of money is invested each month for a specified time period. Three things have to be considered here:

1. The first is the amount that is invested each month.
2. The second is the frequency of investment. Most people select the monthly option.
3. The third point here is the duration of the systematic investment plan. Investors can invest in SIPs for as long as they like. They can even extend the SIP and select the time period they are comfortable with. The time period is not too important because if a person invests say, Rs 1,000 a month for a six-month period, then after the time period is over, s/he can run it for another six months or even a year. Even the amount of systematic investment plan can be increased or decreased as per the individual's requirements.

The limit for SIP refers to the minimum amount with which one can start a SIP. Sometimes, mutual funds reduce the limit for a SIP for the convenience of investors. However, this does not mean that all investors have to make use of it by exactly meeting the lower end of the limit. The smaller limit for SIPs is attractive for those individuals who are just starting their investment process or those who cannot afford large sums. Individuals who have just joined the workforce and want to start investing are often unsure about how mutual funds or other investment schemes work. Participating in SIPs is a good way to initiate their investment process to meet future requirements. Individuals from the unorganised sector, having low incomes, also benefit from the lower SIP limit. These individuals can now invest very small amounts in pension schemes. However, individuals who want to build a secure future with the help of mutual funds should invest larger sums to build a large corpus over the years. Investors should also concentrate on the performance of the fund and whether this can help them to achieve their financial goals. That should be the basis for selecting a particular mutual fund scheme. Smaller minimum investment amounts should not determine an individual's investments.

Future shines for gold ETFs

Source: The Economic Times.

Gold ETF's are gradually gaining popularity among investors

There have been several developments in the mutual fund (MF) arena of late. MF houses have also introduced a variety of schemes to cater to the needs of different investors. One such product is gold exchange-traded funds (ETFs). As these schemes got listed on the exchange and started trading, investors need to have a clear strategy of how to invest in them.

Gold ETFs have the basic characteristics of MFs but they are traded like stocks on the bourses. This means that the fund is available for investment on the stock exchange and it can be bought and sold like a normal stock. The ETF is normally linked to an index so that it mirrors the performance of the index and this usually makes it a passive fund. A passive fund is where the fund manager does not take decisions about the composition of the portfolio but makes the investment according to the stated guidelines. In a gold ETF, the fund's performance depends upon the price movement of gold. Hence, the movement in the value of the fund depends upon the movement in the gold price. This makes it a useful tool for those who want to consider gold as an investment option and gain from its price movements. Here, investors do not actually accumulate gold. In case investors require gold, they have to sell the units from the fund and buy physical gold from the market.

Once the gold units get listed, there has to be some strategy with regard to investment in such schemes. The first principle that investors should follow is that they must try to get a significant appreciation when they quote at a higher price. As the price of gold increases, the price of the funds will also rise and vice versa.

When the units are available on the exchange, they can be bought and sold like normal stocks, which gives an indication to investors about the expense that will be incurred. Brokerage charges have to be paid to the broker through whom the units are purchased and sold. This is slightly different from normal MFs where there are additional charges in terms of an entry and/or an exit load when the investment is made. The basic reason for investing in gold ETFs is to earn returns by making use of the yellow metal. Considering the past history of price movements, it's evident that the overall returns will be moderate if attention is not paid to the investment. Holding gold ETFs for the long term does not guarantee above-average returns. This changes if the cost is extremely low and hence, this has to be considered while framing the investment strategy.

Some individuals may want to make regular investments in this arena. However, they must understand that a systematic investment plan is not possible by giving direct instructions like a normal fund. Instead, investors would have to go out and actually buy units at regular time intervals.

Right Strategy Key to Investing in Debt-Oriented Funds

Source: The Economic Times.

Several developments have taken place in debt mutual funds (MFs) of late. The impact of sharp movements in interest rates and high inflation rate is being felt on the debt market, which, in turn, is affecting investors' decision-making process. Hence, investors should make sure they adopt the right strategy for debt-oriented funds. Debt-oriented MFs invest their corpus in various debt instruments. The movement in net asset value (NAV) of the fund takes place according to the impact on the price of debt instruments. Investors should distinguish these instruments from equity-oriented schemes as well as stocks that are listed on the stock exchange because the features and price movements of these instruments differ. There is a clear relationship between the change in interest rates and the change in price of a debt instrument - like a government security or a corporate bond. When the interest rate rises, there's a fall in the value of the security, which leads to a fall in the NAV of the fund that holds the security. On the other hand, a fall in interest rate will lead to a rise in the price of the debt security and a rise in the NAV of the fund holding the security. Several debt-oriented schemes are present in the market - these range from short-term liquid schemes to gilt funds that have long-term government securities in their portfolio. Let's take a look at what should be the strategy. If investors have money to spare, they should invest it in liquid and short-term schemes, since there is a liquidity crunch in the short-term market. This increases the chances that on days there's a sudden shortage of funds, there will be a spike in the overnight rates, which will benefit liquid and short-term schemes. This can be useful for investors as their short-term money can generate earnings, rather than simply lying around. Meanwhile, no further investments should be made in schemes which invest in medium to long-term instruments. Any further hike in interest rates will have a negative impact on these schemes. This leaves us with schemes like floating rate and MIPs. Floating rate funds can cope with this situation better than income or gilt funds, but investors should not expect too much. There's always some time before floating rate funds feel the impact of a change in interest rate on their holdings. MIPs could also face a tough time as their performance, to a large extent, depends upon that of the equity market. Till it continues booming and the debt market is in a turmoil, these schemes carry greater risk. The only clear winner here is fixed maturity plans that will see a rise in earnings. Since these are close-ended schemes providing high returns, they will be a hit among investors.

Take Your Pick

1. There is a clear relationship between change in rates & change in price of debt instrument
2. If you have money to spare, invest it in liquid and short-term schemes, since there is a liquidity crunch in the short-term market
3. There's always some time before floating rate funds feel the impact of a change in interest rate on their holdings

Exchange Traded Index Funds-- all Explained

Source: The Hindu Business Line

Exchange Traded Funds are index funds whose units traded on the stock exchanges. These ETFs passively track specific indices, which could be broad market indices like Sensex or Nifty or sector indices like the Bankex. The investment objective of these ETFs is to generate the same returns as the underlying index. The net asset value (NAV) of one unit of the ETF is a proportion of the underlying index — one tenth, one hundredth etc. Typically, close-ended mutual funds that are listed on the exchange trade at a premium or a discount to the NAV. However, as ETFs have a pre-defined portfolio composition, they tend to trade at prices closer to their NAV. Essentially, every time an ETF falls below the underlying index, there is an arbitrage mechanism that ensures that the gap is filled.
ETFs are convenient vehicles for investors to trade, to invest or to arbitrage. Investors who want to take a call on the market and thus invest in Nifty basket can instead buy in to Nifty BeEs. They can do this intra-day, instead of buying into index funds at the closing NAV.
Sector positions can also be taken. Those who like the banking sector can buy the Bank BeEs. ETFs do not come with the carrying cost that is associated with Nifty future or Bank Nifty. The volatility associated with futures is also absent in the ETFs. So, they would be safer for retail investors, if they do not mind the lack of liquidity in these instruments.
The ETFs on NSE are S&P CNX UTI Notional Depository Receipts Scheme (SUNDER), Liquid Benchmark Exchange Traded Scheme (Liquid BeES), Junior Nifty BeES, Nifty BeES and Bank BeES. The ETF on BSE is SPIcE. A complete discussion on ETFs is available on the NSE website or on http://www.benchmarkfunds.com/

Are debt funds for you?

Source: The Economic Times

Debt funds are open-ended mutual funds which invests in low risk debt instruments like corporate debt, money market instruments, call money etc. The main objective of debt funds is the preservation of principal, accompanied by modest return. Debt funds are ideal for investors who want to take very small risk or who are uncertain with regards to the interest rate scenario or who are uncertain about what they should do with their money in the short term.

Based on the investment profiles, different flavours of debt funds are available in the market. Liquid funds are ideal for investors who have a very short investment time frame (a day or few days). Liquid funds invest in money market instruments and call money. Return from a liquid fund is also very small. Short-term debt fund invests in low-risk debt instruments. They invest in slightly longer period maturity instruments and hence offer better returns than liquid funds. Long-term debt funds invest in longer period debt instruments.

Floating rate funds invest in instruments where the coupon rates (interest rate) are linked to a benchmark like MIBOR (Mumbai Interbank Offered Rate) and therefore provide protection against interest rate fluctuations. Gilt funds invest only in government securities (investments with government backing).

There is a basic question that comes to an investor’s mind while discussing a debt fund. Why invest in a debt fund when bank fixed deposits offer almost similar returns and with zero risk? There are a few basic differences which investors should carefully weigh before making the investment decision.

Liquidity:

Investment in debt funds is fairly liquid. An investor can exit from the fund anytime he wants. Thus, if liquidity is an investor’s highest preference he should invest in short-term debt funds. Banks impose a penalty clause on premature encashment of fixed deposits which reduce their returns significantly. Usually, short-term debt funds and liquid funds do not charge any entry or exit loads.

Tax

Since Section 80L (which used to provide for tax-free interest income up to Rs 15,000 per annum) has been omitted, interest income from fixed deposits is subject to income tax. For investors in the highest tax bracket, income tax takes off almost one-third of their interest earnings. On the other hand, mutual funds pay dividends which are tax-free in the hands of investors. Tax in this case is borne by the mutual fund schemes (effectively the returns are impacted by dividend distribution tax of around 14 percent of profit). Therefore, investors in the highest tax bracket could consider investing in short-term debt funds and investors in lower tax brackets (10 percent and 20 percent) can invest in bank fixed deposits.

Objective

If the highest preference is capital preservation (absolutely zero risk) then bank fixed deposits should be the call. While investing in a debt fund an investor should look at the track record of the fund, the fund house and the fund management team (i.e. how wellexperienced is the team inmanaging debt funds). Investors can also browse through the fund’s fact sheet to check the credit profile of the debt fund. A high proportion of AAA rating (highest safety) instruments indicate that the fund is taking the least credit risk. Lower proportion of AAA-rated instruments with a lot of AA-rated instruments indicates more risk and therefore more returns. Gilt instruments have the highest credit rating but they have high interest rate risk too.