Debt and hybrid funds

I have met few people recently who are aware of mutual funds and have been investing in them for quite some time, however it was surprising for me that they equate mutual funds to directly equity funds. They were not aware of the debt funds at all, leave apart the different categories of these funds and how they can leverage them.

Well this prompted me to pen down some basics on the debt and hybrid funds

What are debt funds?

Debt funds are basically mutual funds which invests full or part of their corpus in debt instruments like company bonds, govt bonds, loans to state governments, structured debts, debenture said etc. These instruments are rated by credit agencies (AAA and A1 ratings considered safer).

These instruments are slightly riskier than your fixed deposits and hence the institutions offering them compensate this risk by offering higher return. These instruments vary on maturity, the nearer the bond to its maturity the lower the risk and lower the premium. And hence, funds investing in bonds of longer maturity typically generate more returns than the ones investing in shorter maturity bonds.

Debt funds provide you an opportunity to earn more than your bank fixed deposits with tax benefits. From the tax benefit perspective just remember - for investment in debt funds for over 3 years your income is taxed @20% with indexation benefits.

Like equity funds there are both open ended and close ended funds. Most of the debt funds are open ended, however there are close ended funds typically called Fixed Maturity plans. They can only be subscribed during NFO's and can only be redeemed on maturity. FMPs are a very good alternative to fixed deposits in banks.

Debt funds on basis of debt maturity period

This classification is based on the maturity period of the debt instruments. It has nothing to do with how long you are holding the fund. 

Liquid Funds	Upto 91 days
Ultrashort term funds	Typically 91 days to 18 months
Short term funds	Typically 12 months to 36 months, sometimes even more
Income Funds	Really Flexible, 1 year to even 15-20 years

 Apart from this there are special funds that only invest in securities issued by central or state governments or provide loans to govt. These are called Gilt funds, Unlike bonds issued by companies, the chance of the Government defaulting on its loan obligation is significantly lower. 

Now, a combination of maturity and gilt nature provide the following options 

• Short term gilt funds 
• Medium-long term gilt funds 

All, the fund types mentioned above are the ones that only invest in debt instruments with no component of equities at all. 

Debt funds with mix of equity (Hybrid Funds)

These are basically funds that are classified as debt funds as they have major portion of their corpus invested in debt instruments and less in equity. Their tax treatment is same as that of any other debt fund. 

The classification here is based on the amount of corpus investible in debt and equities. 

  

Conservative Debt Funds	Upto 10% equity and rest in debt
Moderate Debt Funds	Upto 20% equity and rest in debt
Aggressive Debt Funds	Upto 30% equity and rest in debt
Equity oriented Debt funds	More than 65% in equity rest in debt

Now, since equity oriented debt funds have more than 65% in equity the tax treatment of them is same as that of equity funds. This is a very important factor to keep in mind while working with these funds. 

Asset allocation funds

These are special funds, where an investor does not need to bother about how much to put in equity and how much in debt. These funds makes the asset allocation decision between equity and debt based on the fund manager's view of the market direction and try to optimize the returns for the end investor. 

They are also called fund of funds and invest in other debt or equity funds. Note that due to this nature of these funds, they have a double incidence of expense ratio on your investments - one at the actual fund level and another at the asset allocation fund level. 

Arbitrage funds 

These funds aim to capture arbitrage opportunities in the cash and derivative market and invest some portion in the debt segment. In layman terms, since the market can never be in synch on the prices of the same stock at two different places - they take advantage of this difference. For instance, it's like you buy an item at flipkart on discount and sell the same on amazon at MRP, the delta/arbitrage is yours. 

I believe this gives you a holistic view of the debt and hybrid funds and would help in taking more informed decisions for your investments.