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Types of debt funds
Debt funds are not only tax-efficient but can also offer higher returns to investors. Five different types of debt funds in which you can invest, based on your goals and investment tenure.
1 Gilt funds
These funds invest in all types of government debt, including bonds issued by the central bank on behalf of the Centre as well as those issued by the state governments. Since gilt funds invest in papers backed by the governments, they carry zero default risk. However, that does not mean they are safe from all aspects: Interest rate risks could be a concern. In fact, long-term gilt funds are the riskiest among debt funds, as they are most sensitive to interest rate changes.
Who Should Invest
Only those who are comfortable with a high degree of risk and looking for capital appreciation instead of protection should invest in a gilt fund.
Underlying bond prices will fluctuate wildly and will reflect in the fund's NAV.
Time Horizon
Investors should ideally put money in a long-term gilt fund during a declining interest rate scenario with a time horizon of at least 18-24 months. You should invest in a short-term gilt fund for about one year.
2 Short-term funds
They invest in debt securities, such as commercial papers (CP), Certificate Of Deposits (CD) and bonds with a maturity of 3-6 months. They are not affected by changes in interest rates, so the returns profile is mostly consistent. But they tend to give slightly higher returns in comparison to liquid funds as they invest in slightly longer tenure papers.
Who Should Invest
Investors looking to park surplus money, but want to earn higher return than a liquid fund can invest in a short-term debt fund
Time Horizon
Short-term funds are best suited for an investment horizon of 6-12 months.
3 Income funds
These funds invest corpus across debt instruments, such as bonds, corporate debentures and government securities. They can also invest across a range of maturity profiles, i.e. they have the flexibility to invest in short-term instruments of upto 1-2 years as well as in long tenure papers of upto 15-20 years. These funds typically take aggressive calls based on the interest rate outlook to take advantage of the rate movements.
Who Should Invest
This type of fund works well for long-term investors, who have a high risk appetite since there is high interest rate risk associated with it. Invest in an income fund if you want to gain from both rising and falling interest rate scenarios.
Time Horizon
Although income funds give the best returns in a falling interest rate scenario, one can invest across the entire rate cycle to earn good returns from them.
4. Fixed Maturity Plans
FMPs have a fixed tenure. They invest in papers with matching maturity. They are typically held till maturity and, therefore, takes away the interest rate risk. Even if interest rates move up, the fund NAV is not affected. FMPs offer returns that are relatively predictable, though not guaranteed. However, there is some reinvestment risk involved if interest rates prevailing at maturity are lower.
Who Should Invest?
FMP is the answer for those looking to park their money for a fixed tenure during uncertain interest rate movements.
Time Horizon
Opt for long-term FMPs, say, for 3-5 years, if you are looking at high yields. You may use shorter tenure FMPs in the 3-6 month horizon if you want to take advantage of a sharp spike in short-term rates.
5 Liquid funds
As the name suggests, these funds invest in highly liquid money market instruments, such as Treasury Bills, inter-bank call money market, Commercial Papers and Certificates of Deposit.
Returns on these funds are the most stable among debt funds. These provide easy liquidity and can even be used as a substitute for a savings bank account if you plan to park your surplus amount.
Who Should Invest
Liquid funds are ideal for investors who have a lot of money lying idle in the savings account and are interested in earning better returns compared to what banks offer.
Time Horizon
Ideally, liquid funds should be used for very short investment time frame, say, as low as just a few days to a couple of months. Do not invest for a longer period as these offer low single-digit returns at best.
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