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A BEGINNER’S GUIDE TO MUTUAL FUNDS

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Debt Funds Offer Variety
There are a wide variety of debt funds based on their portfolio and maturity pattern

Debt funds are mutual funds that invest in fixed income securities like bonds and treasury bills. They are mainly classified by the term to maturity and type of underlying instruments in the portfolio besides the structure of the fund.

Maturity is the date on which bonds are redeemed and the principal refunded to the investor. One must also note that demand and supply (prices) of bonds are also dependent on the maturity of the bond besides the interest rate scenario.

For example, when interest rates fall, bonds offering high interest rates gain value. Further, the bond which has more years left till maturity would gain more than the one which has fewer years left to mature. After all, the bond which will mature later will not only pay more interest but will pay it for a longer period. Similarly when interest rates rise, the bonds with shorter maturities are preferred so that they can be redeemed quickly to buy new bonds offering higher interest rates. This continues till the cycle reverses. In short, there is demand for longer maturity bonds when interest rates fall and vice-versa when interest rates rise.

At this juncture, it is also important to understand residual maturity and total maturity of a bond. Residual maturity refers to the time left till the redemption date of the bond. In this sense, a twenty-year bond that was issued eighteen years ago has a residual maturity of two years (20 less 18) and total maturity of twenty years. However, this bond and a freshly issued two-year bond have the same residual maturity. If all other things about these two bonds remain the same then change in interest rates would impact their value almost equally. From this, it is clear that residual maturity matters more rather than the total maturity of the bond. Thus the risk (fluctuation in prices) and return level of a bond would be dependent on its residual maturity. The shorter the maturity of the bond, lower would be the fluctuation in prices or risk and hence lower would be the potential for capital gains (or loss). In contrast, longer maturity bonds will carry a higher risk but also have the potential for higher gains (or loss).

Pure debt mutual funds are generally classified on the basis of their portfolio maturity pattern as follows:

1.Upto 3 months - Liquid and money market Funds

2.From 3 months to 1 year - Ultra short term debt funds

3.From 1-3 years - Short term debt funds

4.More than 3 years - Income funds

Ofcourse, there may be some variation to the above maturity pattern but broadly one can classify debt funds in this manner. Another way to classify debt funds is by the nature of the underlying portfolio (holdings) like Gilt Funds and Credit Opportunity Funds.

Gilt Funds - invest only in government securities, viz., central and state government bonds and treasury bills. These securities are also called gilts and the funds are called Gilt Funds or Government Securities Funds or G-Sec Funds. They carry a lower credit risk as the chance of the Government defaulting on its loan obligation is almost negligible.

Credit Opportunity Funds - are funds which invest across the credit spectrum, viz., AAA and/ or AA rated long term securities or A1+ and / or A1 rated short term instruments. The credit rating may even be lower than those illustrated or a combination thereof. In order to compensate investors for taking a higher credit risk, lower rated securities offer higher interest rates to investors. Credit opportunity fund capitalize on this spread (between higher and lower rated securities) and aim to provide better yields/ returns to investors. Another way to classify debt funds is by their structure. Most debt funds are open ended but there is a large category of debt funds which is also closed ended like

Fixed Maturity Plans - are launched for a pre-defined period that may range from 1 month to even 5 years. Investors cannot redeem directly through the fund house before the maturity date but can do so only on the stock exchange as FMPs are listed. Since the volumes on stock exchanges are abysmal, FMPs are fairly illiquid till maturity. FMPs are usually compared to bank fixed deposits owing to the structure though FMPs do not offer any assured returns. The final returns delivered by FMPs are usually in line with the prevailing yields on fixed income instruments for the specified maturity less expenses.

Interval Funds - A slight variation of the above are called ‘Interval Funds’ as they provide an exit window to investors at pre-specified ‘intervals’. Interval funds are not launched for a pre-defined period as investors may redeem at the ‘interval’ or may continue to remain invested/ make additional purchase in the scheme. The ‘interval’ or the time gap between two windows is called as ‘specified transaction period’ and it may vary from a fortnight to a month or a few months to even a year.

SUMMARY

Pure debt funds are mainly classified by the residual maturity of the underlying portfolio (liquid, ultra short term debt, short term debt and income funds) as well as the type of instruments in the underlying portfolio (gilt and credit opportunity funds) besides the structure of the fund (Fixed Maturity Plans or Interval Funds). The risk-return characteristics of a debt fund are also dependent on the maturity profile. A longer maturity fund is more riskier than a shorter maturity fund though the former has a higher potential to make capital gains (or even loss).

Next To Come: Debt Funds Or Tradational Savings