Why should you invest in a debt mutual fund?

Why should you invest in a debt mutual fund?

Debt or bond mutual fund schemes are completely different from equity mutual funds. Not only are they much safer but also the risk and volatility associated with them are also low. Therefore, their returns are also lower when compared to equity funds.

These mutual funds invest in government bonds, securities and other cash related products.

What are bonds?

Companies or state and central government bodies issue bonds to raise money for various projects. Let’s take the example of a government bond.

Every government needs money or capital for financing infrastructure projects and other needs. i.e. they need money to build roads, railways, hospitals, and other public utilities.

The taxes we pay as citizens are usually not enough to fund these initiatives. Regular taxes go towards regular expenditure including government official’ salaries, travel and other operational costs.

This is why they issue bonds. What it essentially means is that if you buy a government bond of Rs 1000, the government guarantees to return back your money after a certain period of time at a fixed rate of interest. Since governments usually don’t default on their loans, government bonds are considered as relatively safe investment options.

Types of bonds

The bonds are also of different types, namely short, medium-term or long-term bonds. If you have to build a highway, one will incur a large cost right now and the money will be recovered via tolls in the next 20 to 30 years. Thus the government will issue long-term bonds to fund such capital-intensive projects.

On the other hand, if the government requires capital to build schools or hospitals, the cost may be recovered in a much shorter time frame – and hence will issue short-term bonds.

Mutual fund schemes, which invest in, and buy and sell these bonds are known as debt or bond mutual fund schemes.

There are various bond funds, which can be used to meet specific financial objectives. Bond mutual funds invest in debt securities, money market securities or in longer-term debt securities, or a combination of the above.

Ultra Short Term Bond Fund or Liquid Funds

These funds invest in securities maturing in less than 1 year. The primary source of return is interest income. They seek to provide safety of principal and superior liquidity.

Suitability: Investment horizon of less than 1 year.

Short-Term Funds

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

Suitability: Investment horizon of 1-3 year.

Medium-Term Funds

These funds combine medium-term debt securities with a small allocation to longer-term debt securities. Medium-term plans earn interest from medium-term securities, interest and capital gains from medium-term and long-term debt securities.

Suitability: Investment horizon of 3-5 year.

Long-Term Debt Funds

Market interest rates and value of a bond are inversely related and any fall in the interest rates can cause 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 (duration of investment) of the portfolio – higher the tenor, greater the impact of changes in interest rates.

Suitability: Investment horizon of more than 5 years.

For all practical reasons, creating a portfolio with a combination of ultra-short term debt fund and the short-term fund will meet the objective of most of the investors.