Understanding Debt Mutual Funds — Part 1
By now, most of you would know that mutual funds do not only invest in stocks (equity) and there are debt mutual funds which invest in fixed income products (for example: bonds). Like equity mutual funds, there are a large number of sub-categories within debt mutual funds. All these categories have been defined by SEBI (the securities market regulator), and in the next series of articles we will explain you these categories in terms of how they differ from each other and the kind of securities they invest in.
What are debt mutual funds?
Before understanding the sub categories, let us understand debt mutual funds. Debt mutual funds are a category of mutual funds that invest primarily in fixed income instruments (such as bonds) issued by government, public and private companies. Or simply you can understand that the money you put in a debt mutual fund, is in turn lent out to private/public companies or government bodies. Mutual funds get interest from these borrowers which is reflected in the returns of the debt mutual fund.
Types of Debt instruments
Debt mutual funds mainly invest in the following different types of instruments:
- Tri Party Repo: This is an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.
- Commercial Paper (CP): Short term borrowings by corporates and financial institutions up to 1 year.
- Certificates of Deposit (CD): Short term deposits with banks up to 1 year and financial institutions up to 3 years.
- Treasury Bill (T-bill): Short term securities of Indian Government with maturity less than 1 year.
- Corporate Bond: Long term borrowings by corporates with a maturity of more than 1 year.
- Government Bonds: Long term borrowings by state/central government with a maturity of 1 year or more.
Debt mutual funds can be broadly classified in two buckets:
- Theme based: SEBI has defined some categories based on the kind of instruments the mutual fund invests in, for example, corporate bonds, Government bonds, etc. Typically, the greater the risk in the instruments that the mutual fund holds, the higher the expected returns.
- Maturity/Duration based: SEBI has defined categories of mutual funds based on maturity or Macaulay duration of the fund. Put very simply, Macaulay Duration is the time taken for a bond to repay its own purchase price in present value terms. Generally, the longer the maturity of the instruments that the mutual fund holds, higher the Macaulay duration of the fund. Typically the longer the maturity/duration of the fund, the higher the expected returns. But higher duration also leads to higher volatility in returns with change in interest rates.
In this article we will discuss only maturity/duration based debt mutual fund categories. There are ten such categories according to SEBI’s definition, and each of them are explained below: