Using Debt Funds For Your Investment Needs

Debt funds have grown in popularity in recent times, with deposit rates having fallen to near 6.5% levels across maturities in the last few months. However, many investors still remain confused about what sort of debt fund is suitable for what purpose. This should serve as a simple clarification.

Liquid, Cash of Ultra Short-Term Debt Funds
Liquid Funds (or Cash Funds/ Ultra Short-Term Debt Funds) invest into bonds that have very short residual maturities (such as those maturing in a few weeks or months). They also deploy a portion of their corpus into T-bills issued by the government. They will usually have moderate credit rating profiles, coupled with very low modified durations; and therefore, very low interest rate sensitivities. At present, one can expect annualized returns of 6.5% to 7% from these funds. They are ideal for parking money for a few days to a few weeks.

Short Term Debt Funds
Short Term Debt Funds or Short-Term Funds pick up bonds that are maturing within the next two to three years, and usually prefer investing into higher rated bonds. They are moderately sensitive to interest rate changes - for instance, if the RBI were to increase rates by 25 bps, one would expect a negative impact of approximately 0.5% on the NAV's of most short-term funds. Short Term Funds should ideally be invested into for a minimum time horizon of 12 months. In a stable interest rate scenario, one can expect roughly 7.5% to 8% returns from these funds at this point in time.

Corporate Bond Funds
As the name suggests, Corporate Bond Funds or Credit Opportunities Funds invest into bonds issued by companies. In effect, they take on a deliberate credit risk by selecting high yielding bonds, often with medium to low credit profiles - with the assumption that their credit profiles would improve over time, thereby reducing their credit spreads and increasing their prices. Strong risk management practices incorporated by the top AMC's reduce the risk of over-exposure to bad credit. Defaults can impact NAV's of corporate bond funds, although most exposures are kept at under 2%. Well managed corporate bond funds can even provide double digit returns in the current environment. However, in scenarios where over-leveraged companies default en masse, corporate bond funds underperform. There have been years where corporate bond funds have provided returns of just 2-4%. One needs to have a minimum time horizon of two years to invest in this category of debt funds.

Income Funds
Income Funds tend to focus less on achieving capital gains, and more on accruing coupons from moderate to high quality bonds. They make a lot of sense in the current environment, where yields seem to have more or less reached an interim bottom, thereby limiting the scope for achieving serious capital gains from bonds. They should be entered into with a minimum time horizon of 1.5 to 2 years, and one can expect returns in the range of 8% to 8.5% (annualized) from them.

Dynamic Bond Funds
The performances of Dynamic Bond funds are heavily contingent upon the competence and investment research capability of the asset management company in question. Reason being, they can switch between strategies - sometimes focusing on accruing coupons, sometimes focusing on achieving capital gains, and then again later, on benefiting from narrowing credit spreads. Their returns are very difficult to predict, and could range from 7% to 10%, depending upon the efficacy of the fund management strategies employed by the asset management company. Dynamic Bond Funds ideally require a time horizon of 2.5 to 3 years.

GILT Funds
GILT Funds invest into Government Securities. They are popularly believed to be low risk, although this isn't the case. Long Term GILT funds have high maturity portfolios (ranging from 10 to 20 years), which leaves them open to the possibility of a severe NAV correction in rising yield scenarios. A 25-bps hike in interest rates by the RBY could reduce NAV's of long term GILT funds by as much as 1.5% to 2% immediately. Shor Term GILT funds are lower risk, and have the potential to deliver returns of 6.5% to 7% in the present scenario, with minimal NAV volatility. Long Term GILT funds should be invested into for a minimum 3 year timeframe, whereas Short Term GILT Funds can be used to part 1 year moneys.