What are the different types of debt funds in India?

by Manshu on December 1, 2010

in Fixed Deposits

This is the second post from the Suggest a Topic page, and in this post I take a look at the different types of debt funds available to Indian investors.

1. Monthly Income Plans: I start with MIPs first because I have already written a post about them in the past, and these are funds that primarily invest in debt instruments, and try to give you a monthly income in the form of dividends. The income is not guaranteed of course, and they only pay out a dividend if they are profitable for that time period.

This type of a debt fund is for people who have a big corpus initially, and would like to generate a monthly income for them with low to moderate risk. When I wrote that last post about MIP I got an email asking if you could do a SIP in a MIP. While that rhymes together nicely, I don’t see merit in investing monthly in a product whose premise is generating a m0nthly income, so I’d avoid that.

2. Capital Protection Plans: Capital Protection Plans are debt instruments that guarantee your capital, and then invest a portion of the funds in equity in the hopes of generating excess returns. I personally don’t see any compelling reason to invest in these type of funds because you can create such a portfolio yourself fairly easily, and avoid paying the mutual fund fees that they will charge you.

3. Gilt Funds: Gilt Funds invest in government debt viz. the debt issued by Reserve Bank of India on behalf of the government. They also invest in securities issued by state governments. The investments are done in ultra safe paper because they are backed by the government itself but that doesn’t mean the Gilt Funds are risk free. They can go down in value because when interest rates rise the value of the debt goes down. So, there could be a possibility that the debt funds lose some part of their NAV also.

Gilt funds can be short term gilt funds, or long term gilt funds. The short term Gilt Funds are meant for people looking to invest their money for shorter durations of say 3 – 6 months.

4. Fixed Maturity Plans (FMPs): Fixed Maturity Plans (FMPs) are quite similar to fixed deposits in the sense that these funds are usually close ended, which saves you from interest rate risk, and even if rates move upwards the fund NAV doesn’t go down. The way the fund works is that a fund house announces a new fund offer specifying the duration of the fund say 18 months or so, and then they collect money from investors which is then invested in debt of the same duration.

These funds have become popular because of a sort of a tax advantage where interest on fixed deposits are charged at a higher tax rate than dividends from FMPs for individuals who are in the higher tax bracket.

The risk of investing in FMPs is that they might invest the money in lower quality debt, and then during times such as the last crisis might come under pressure, and in that sense your capital is not really assured as it is in the case of say a fixed deposit with SBI.

5. Liquid Funds: Liquid Funds are funds that are used by investors for extremely short time durations, and in most cases instead of a savings account. The current savings account interest rate is 3.5% per annum, whereas funds like the SBI Magnum Cash Liquid Float, LIC MF Liquid Fund and JM High Liquidity Fund have returned over 5% since last year. These funds are not meant to keep money in for longer durations because these same funds return in the range of 6.5% when you look at their returns for the past 3 years.

6. Floating Rate Funds: Floating rate funds are funds that invest in predominantly floating rate debt instruments, and can invest in government and corporate securities.

You can have a short term floating rate fund, or a long term floating rate fund. A look at the top floater plans on the Moneycontrol page shows that the 1 year return for the funds that performed in the last year range in 5.3 to 6.1% area, and the 3 year returns range between 6.9% to 7.9%.

Other long term and short term funds: Outside of the categories mentioned above there are debt funds that target long term debt, or short term debt, but may not be strictly a liquid fund, or a floating rate fund. If you look at a bond fund, and by its description its not clear how it fits in the earlier categories then you will have to dig in deeper into the fact sheet or information document or just the returns over the years to see how it did, and get a feel for the nature of the fund. An example would be the SBI Dynamic Bond fund – you will have to look at the information document to dig deeper and see what the fund is all about as the name alone doesn’t indicate what this is all about.

I have tried to cover all the major categories, and if you think that I have left out something then please leave a note, and I will update the post with that information.

Next week, I am going to make a comparison between the debt funds and fixed and savings deposits.

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