Chapter 10 : Learn Different Types of Mutual Funds

Aleena wants to invest in mutual funds but she is not sure she wants to explore equities. She has a low-risk appetite and would prefer debt mutual funds. Just like equity mutual funds have different categories, so do debt mutual funds. There are different debt funds that invest in debt securities with specific Durations, for specific goals or for a specific risk profile. Let’s take a look at the different options available to investors.

Types of Debt Mutual Funds

1. Overnight Funds

Overnight debt funds are schemes that invest in debt securities with a maturity of just a day. They are perfect for investors who want to park their funds for a short while. These are usually considered extremely safe investments, just like savings bank accounts.  

2. Liquid Funds

Liquid funds are debt schemes that invest in debt securities with maturity of up to 91 days, like treasury bills and commercial papers. Typically, they invest in high-grade debt securities with short maturity periods. While risk is low, yields are also quite low.

3. Ultra-Short Duration Funds

Ultra-short Duration funds invest in debt instruments with a Macaulay Duration of 3 to 6 months. They usually provide higher returns than FDs as well.

4. Low Duration Funds

Low Duration funds invest in debt instruments with a Macaulay Duration between 6 and 12 months. Due to a slightly longer Duration, these funds are considered a little more risky than ultra-short Duration funds.

5. Money Market Funds

These debt funds are open-ended schemes that invest in money market instruments with maturities of up to a year, like cash, treasury bills and commercial papers.

6. Short Duration Funds

Short Duration funds invest in debt securities with a Macaulay Duration of 1-3 years. This means they can invest in short-term instruments as well as other securities like government bonds, debentures. corporate bonds, etc.

7. Medium Duration Funds

These debt schemes invest in debt securities with a Macaulay Duration of 3- 4 years.

8. Medium to Long Duration Funds

Medium to long Duration debt schemes invest in debt securities with a Macaulay of 4-7 years. These funds carry high interest rate risk and can be a good choice in the falling interest scenario.

• Interest rate risk is the risk that an increase in interest rates in the economy will reduce the price of a fixed-income security. As interest rates rise bond prices fall, and vice versa.

9. Long Duration Funds

Debt schemes investing in debt securities with a Macaulay Duration of more than 7 years are called long Duration funds. Since these funds invest in securities with longer Duration, they carry higher risk than the other funds mentioned above. Despite this, long Duration debt funds are considered less risky than equity funds.

10. Dynamic Bond Funds

Dynamic debt funds can invest in debt securities across Durations. Fund managers invest according to the prevailing interest rate cycle in the market. For instance, if a fund manager expects a fall in interest rate, they will go in for a long Duration portfolio but if the interest cycle reverse, they may rebalance the fund portfolio to short Duration.

11. Corporate Bond Funds

While all funds mentioned so far invest mostly depending upon the Duration of debt securities, corporate bond funds invest depending on credit rating of securities. These funds invest a minimum 80% of fund asset in highest-rated corporate bonds. They provide the dual benefit of safety and good returns compared to other debt funds. You should always check the credit rating of corporate bonds from the portfolio of the fund you’ve invested in.

12. Credit Risk Funds

Credit risk funds also invest in corporate bonds. These funds invest at least 65% of total fund money in below highest rated corporate bonds. Since their ratings are lower, these bonds pay higher interest to compensate for credit risk. These funds are not for risk-averse investors.

• Credit risk is the risk that a debt security issuer may default or fail to make a payment. The higher the possibility of default by the lender, higher the credit risk of the instrument.
• AAA rating is the highest credit rating, meaning they are considered the safest.

13. Banking and PSU Funds

These funds invest a minimum of 80% of total fund money in debt securities from banks, Public Sector Undertakings (PSUs) and public financial institutions.

14. Gilt Funds

These are debt schemes that invest at least 80% of their fund money in government securities across with different maturity periods. Risk of default is low in gilt funds but the interest rate risk is high.

15. Gilt Funds With 10-Year Constant Duration

These debt funds invest at least 80% of their fund assets in government securities having a constant Duration of 10 years. Interest rate risk of these funds is fairly stable because of the constant Duration.

16. Floater Funds

Floater funds invest at least 65% of fund money in floating-rate instruments.

• Floating rate instruments do not pay a fixed coupon. Instead, their coupon rate is linked to a benchmark. For instance, RBI’s Floating Rate Savings Bonds are linked to National Savings Certificate rates, which are reviewed every quarter.

Fixed Maturity Plans

Debt mutual funds offer something called fixed maturity plans or FMPs. While all the above-mentioned funds are open-ended funds, FMPs are closed-ended schemes, meaning you can invest only during NFOs and redeem them at maturity.

FMPs invest only in securities where the maturity period of the security is equal or lesser than the maturity of the FMP. For example, if an FMP has a maturity of 1 year, then its portfolio will consist of only those securities which have a maturity of one year or less than one year.

• They have a maturity of 3 months to 5 years in general.
• While they try to offer fixed returns, it is not guaranteed. Instead, they provide returns in line with prevailing market yields for the same tenure.  
• FMPs don't generate returns through capital appreciation and try to generate returns only based on yield to maturity.

Indexation Benefit of Debt Mutual Funds

If you stay invested in a debt mutual fund for 3 years or more, you will have to pay long-term capital gain tax on it with indexation benefit.

Indexation adjusts the purchase price of a security or investment to account for inflation. This means that if the purchase price is higher, your tax will be lower. This is one major advantage that debt funds offer when compared to FDs.

Every year, the government declares cost of inflation index (CII) to calculate the impact of inflation on purchase price.

Let's understand this with an example:

Mr. A purchases an FMP of 37 months for Rs. 100,000 on April 1, 2015 and sells it on April 30, 2018 at Rs. 130,000. As per government data, CII for the years 2015-16 and 2018-19 is 254 and 280 respectively.

Indexed cost of acquisition = 280*100,000/254 = Rs. 110,236

Long term capital gain with indexation = Rs. 130,000 – Rs, 110,236 = Rs 19,764

Long term capital gain tax = Rs. 19,764*0.2 = Rs 3,953

If you invest during the last few days of a financial year, you can take advantage of double indexation benefit. For instance, if Mr. A purchased a 37-month FMP for Rs. 100,000 on March 31, 2015 and sold it on April 29, 2018 at Rs. 130,000, his purchase year would be 2014-15. With just a single day’s difference, the CII taken into account would be CII for the year 2014-15 is 240.

Indexed cost of acquisition = 280*Rs. 100,000/240 = Rs. 116,667

Long term capital gain with indexation = Rs. 130,000 – Rs. 116,667 = Rs. 13,333

Long term capital gain tax = Rs. 13,333*0.2 = Rs. 2,677

This benefit is called double indexation.

Summary

• Debt mutual funds can be classified in the following categories:
  • Overnight funds
  • Liquid funds
  • Ultra-short Duration funds
  • Low Duration funds
  • Money market funds
  • Short Duration funds
  • Medium Duration funds
  • Medium to long Duration funds
  • Long Duration funds
  • Dynamic bond funds
  • Corporate bond funds
  • Credit risk funds
  • Banking and PSU funds
  • Gilt funds
  • Gilt fund with 10-year constant Duration
  • Floater funds
• Interest rate risk is the risk that a change in interest rates in the economy will reduce the price of a fixed-income security.
• Credit risk is the risk that a debt security issuer may default or fail to make a payment.
• Fixed Monthly Plans (FMPs) are closed-end debt funds having a fixed maturity period which can be bought during NFO only.
• All debt funds including FMPs provide indexation benefit in the long term, i.e. if you stay invested for more than 3 years. Indexation adjusts the purchase price of a security or investment to account for inflation.

That’s all you need to know about debt mutual funds for now. In the next chapter, we will discuss an interesting investment instrument called Exchange-Traded Funds (ETFs).