Debt Mutual Funds invest in debt securities, may invest in money market securities or in longer term debt securities, or a combination of the two. The primary investment objective of liquid and debt funds is regular income generation. However, since the longer term debt markets offer the scope for capital growth, debt funds are offered along the yield curve, spanning very short term to long term products.

Short Term Debt Funds

Money Market or Liquid Fund is a mutual fund for very short term investment. The primary source of return is interest income. Liquid fund is a very short-term fund and seeks to provide safety of principal and superior liquidity. It does this by keeping interest rate and credit risk low by investing in very liquid, short maturity fixed income securities of highest credit quality.

It is suitable for retail investors who:

  • Are looking for very safe investment option and,
  • Have less than 3-6 months investment horizon.

Ultra short-term plan also known as treasury management funds, or cash management funds. They invest in money market and other short term securities of maturity up to 365 days. The objective is to generate a steady return, mostly coming from accrual of interest income, with minimal NAV volatility.

It is suitable for retail investors who:

  • Are looking for very safe investment option and,
  • Have less than 1 year investment horizon.

Short Term Plan combines short term debt securities with a small allocation to longer term debt securities. Short term plans earn interest from short term securities and interest and capital gains from long term securities. The volatility in returns will depend upon the extent of long-term debt securities in the portfolio.  Short term funds may provide a higher level of return than liquid funds and ultra-short term funds, but will be exposed to higher risks.

It is suitable for retail investors who:

  • Are comfortable taking some level of risk for an extra return and,
  • Have investment horizon between 1-3 years.

Long Term Debt Funds

Market interest rates and value of a bond are inversely related, any fall in the interest rates causes a gain in a bond portfolio and vice versa. Therefore in a falling interest rate scenario, when investors in most fixed income products face a reduced rate of interest income, long term debt funds post higher returns. The extent of change in market prices of debt securities is linked to the average tenor of the portfolio – Higher the tenor, greater the impact of changes in interest rates.

It is suitable for retail investors who:

  • Are comfortable taking some level of risk for an extra return and,
  • Have atleast 3 year investment horizon.

Apart from the above mentioned broad categories of debt funds, there are other debt funds to meet specific needs of investors:

Credit opportunity funds a new category that has emerged among the debt funds in India recently. The fund focuses on accrual income from corporate bonds of tenor 3 to 5 years. The investors earn a high return owing to high return.

It is suitable for retail investors who:

  • Are looking for regular income from a debt fund. And,
  • Have at least 3 year investment horizon.

Gilt Funds invest in government securities of medium and long-term maturities. There is no risk of default and liquidity is considerably higher in case of government securities. However, Prices of government securities are very sensitive to interest rate changes. Long term gilt funds have a longer maturity and therefore, higher interest rate risk as compared to short term gilt funds.

It is suitable for retail investors who:

  • Are looking for very safe investment option and,
  • Have at least 5 year investment horizon.

Dynamic debt funds funds do not have any restriction with respect to security types or maturity profiles that they invest in.

It is suitable for retail investors who:

  • Are comfortable taking some level of risk for an extra return and,
  • Want a fund manager to actively manage their debt portfolio.

Fixed maturity plans (FMPs) are closed-end funds that invest in debt securities with maturities that match the term of the scheme. The debt securities are redeemed on maturity and paid to investors. FMPs are issued for various maturity periods ranging from 3 months to 5 years. The return of an FMP depends on the yield it earns on the underlying securities. They typically invest only in fixed income securities like debentures of issuers with a good credit rating. FMPs are a very good substitute of a bank Fixed deposit.

There have been few significant changes in the recent budget (July 2014) for debt funds. According to the new tax rules on debt funds, the investor has to hold the funds for at least 36 months to qualify for the 20 per cent capital gains tax. If the debt mutual units are held for less than 36 months, it would be taxed according to the investor’s tax slab. This brings debt funds at par with bank fixed deposits in terms of taxation, if it is held for less than 36 months. However, if your investment horizon is more than 36 months, debt funds are still an attractive option.