In the first two parts of the series I talked about the various kinds of mutual funds and about Equity MF schemes. Now let’s come to the fixed income part of the Mutual Funds. Now the fixed income part of the mutual funds essentially serves the purpose of treasury management of companies and in the case of retail investors it gives an alternative to investment in bank fixed deposits. There are a large number of categories of debt mutual funds which can confuse investors to a great degree. However beyond the nomenclature what investors have to know is the time duration for which they are investing. If that is known the fund to be invested into becomes simpler to understand.
The first category of Debt Funds are the liquid funds. Without getting into the details of how they operate the simple guideline is that these funds are appropriate for you if you want to invest for a period of a few days to few weeks. Most liquid funds irrespective of the fund manager will have similar returns in this kind of time frame and for a retail investor the difference is not very significant. Therefore if you are investing only for a few days then you can invest in these schemes.
The second broad category would be the Short term funds. Here the investment horizon can be from a month to a few months but normally less than one year. From this category of funds the importance of the fund manager starts coming in as the returns of different short term funds can be quite different depending on where they are investing.
The next category of funds are the long term funds where typically the investment horizon will be for more than one year. In the long term category the popular funds are income funds which have a combination of investments into government debt paper as well as that of companies. It is this category of funds where the portfolio of the fund becomes very important. The reason is that in case of debt funds it is very easy to show very good short term performance by investing in higher risk debt papers. In simple terms what it means is that if a company like Reliance is borrowing at 9% a more risky company like DLF will be borrowing at 11-12%. But in debt unlike in the case of equity taking a greater risk for earning just a little bit more does not make sense for investors. For example when you go to place a fixed deposit typically you would go to a known back rather than a small cooperative bank, although that bank might be giving much higher rate of interest. Similar is the case for Long Term Debt funds.
Besides this there are GILT funds that invest in government securities where the safety is the highest in the long term investment segment. However the safety does not mean that there can be no loss. Most investors who are used to fixed deposits think that there should be no losses in debt funds. This is because movement in interest rates impacts the Net Asset Value of the fund. That is the reason why in the case of debt funds it is important that investors invest in funds that are in line with their time horizon.
The best category of debt funds for investors who know what their investment horizon is are the Fixed Maturity Plans. These Fixed Maturity Plans are the best for investors who know that this particular amount of money will not be required for the duration of the FMP. In these schemes what the fund manager does is that he invests in debt papers which are almost exactly matching the time duration of the FMP. As such the expected return and the actual return matches in most in FMP’s as compared to any other category of debt mutual funds. The best FMPs are those which are just above the duration of one year and start at the end of March in any financial year. As all of you would know the financial year in India runs from April to March. Now debt mutual funds long term capital gains tax is 10% without indexation and 20% with indexation. Indexation is broadly something which reprices the investment made by an investor to the date of the sale of the investment or redemption of the investment taking into account the inflation in the economy. Now lets say that an investor is putting money in a one year and 10 days bank deposit at the end of March of 2014 where the rate of interest is 10%. So when he gets the money back in April 2015 he will get an interest rate of 10% out of which the tax will be charged at 30% so the post tax returns are 7%. But in an FMP the return will be the same at around 10% but because the initial investment amount is adjusted for inflation of two years due to indexation the tax outflow might be just 5% and Post tax returns are higher. In conclusion, one year plus few days FMPs that come at the end of March are best for investors with a one year horizon.
Besides this there are some other debt funds like Dynamic funds which seek to combine the benefits of long term and short term investing. However investors in general can stick to the simpler category of funds.
Now briefly touching on Hybrid Funds. Hybrid funds are those which have a combination of equity and debt. A lot of investors might have invested in balanced funds. These funds typically invest between 65-75% into equity and the rest into debt. The advantage for investors here is that the returns are treated like that of equity funds and there is no long term tax and a 15% short term tax. However, the performance of Hybrid Funds vary a lot across fund houses due to the fact that the equity to debt ratio might vary. These funds were popular at one point of time but are no longer fancied and rightly so.
Monthly income schemes are interesting products where 80-85% goes into debt and the rest into equity. These funds became popular with conservative investors in the last bull market as the 15% of equity was giving returns of 20-25% and the debt was giving in line with market interest rates and so the overall returns of the investors got enhanced by around 2% per year. However this can go the other way too as we have seen in the last 5-6 years where due to poor equity market returns MIP’s have not done well.
Now in the first three articles I have touched on the basics on mutual fund investing. Now I will turn to more interesting topics as well as individual scheme analysis.