Know your holdings The world of investing in debt mutual funds can be daunting for a retail investor.

As of now the participation of retail investors in the debt mutual fund segment is small, however, if the structure of developed financial markets is anything to go by, then the Indian investor will mature and evolve into investing in debt mutual funds instead of locking up his reserves in fixed deposits offered by banks and post offices. Our endeavor is to make the investor aware of the dynamics of debt funds. The lay investors awareness of the same tends to be rather abysmal. In this article we cover the most popular instruments that an investor can expect his mutual fund to invest in: CP & CDs Commercial paper (CP) and certificate of deposit (CD) are the two most common instruments held by debt mutual funds across the risk and duration spectrum. These are short term instruments issued to raise capital for a short duration of time, usually less than a year. A commercial paper is issued by a corporate entity or a company. The proceeds are used to fund short term requirements which could arise in inventory management and the like. On the other hand a Certificate of deposit is issued by a bank, and enables the bank to raise bulk deposits. Bonds/Debentures Dynamic and long term oriented income funds are the primary investors in such paper. A debenture is a certificate issued in lieu of money borrowed by a company. When a corporate entity borrows money for a medium to long term period and offers to repay this loan on a definite future date, with an interest payment through the tenure of the loan, it issues a debenture. There are variations to the basic debenture in the form of fully or optionally convertible and non convertible debentures. A convertible debenture is one which can be converted into stock or equity in the company. By offering convertibility the issuer can avail of lower rates of interest. Zero Coupon Bonds While most debt based instruments carry a coupon or interest payment, zero coupon bonds do not carry such a cash flow arrangement. They are instead issued at a discount to their face value, and upon maturity the face value is paid off. Floating Rate Bonds A Floating Rate Mutual Fund is a debt fund that invests predominantly in debt securities with a floating rate of interest. And these debt securities peg their coupon or interest rate payable to a market-driven rate like the Mumbai Interbank Offered Rate (MIBOR). Hence each time the benchmark rate fluctuates; the coupon rate is adjusted accordingly. The primary advantage of these funds is that they are less volatile than other types of debt funds. This advantage arises due to the inherent structure of floating rate bonds. In case of fixed rate bonds when interest rates in the economy change the price of the bond adjusts to make up for the fixed coupon of the bond. While this happens even in the case of floating rate bonds the change in the price of the bond is less drastic due to the periodic change in the

coupon of the bond. There exist dedicated funds which invest in only floating rate bonds. Government Securities The government needs to borrow money, and when it raises money from the public, it issues a certificate which is commonly referred to as g-sec. Government securities include central government dated securities, state government securities, cash management bills and treasury bills. Treasury bills are issued for short term borrowings and are currently issued for tenure of 91 days, 182 days and 364 days. Cash management bills have the same characteristics of a treasury bill but are issued for maturities less than 91 days to meet the temporary mismatch in the cash management of government. Those g-secs which are issued for a period greater than a year are referred to as dated securities. The basic purpose of investing in Gilt funds is to generate returns at negligible risk as it is highly unlikely that the government will default on the debt raised by it. In fact when fund managers want to extend the maturity profile of their portfolios, they usually rely on dated government securities rather than on long term corporate debt. There also exit dedicated funds which invest only in government securities. Securitised Debt Securitisation of debt is a process where a number of loans are packaged together under one debt instrument and sold to investors. The original lender, say a bank, decides to offload some of the long term loans extended by it. Usually the buyer of such debt floats a subsidiary called a special purpose vehicle (SPV), which functions like a trust. This SPV will package these outstanding obligations into an interest bearing bond, which is like a debenture. These debentures are referred to as Pass Through Certificates (PTC). These PTCs are sold to institutional investors. The overall objective behind the securisation of debt is for the bank to reduce some of its risk, and realize payments in the present instead of in the future. For SPVs and the buyer of PTCs the aim is to generate better returns by taking on more risk. Investors can gauge the quality of a PTC through the ratings that are assigned to PTCs by independent rating agencies. The type of loans packaged under a PTC or an asset backed security can vary from home loans, commercial vehicle loans, corporate loans, credit cards, and auto and personal loans. If the original borrower begins to default on the repayment obligation, the SPV will begin to sell the mortgaged assets which back the loan. Due to their higher risk profile, as well as poor trading volumes, Asset backed securities have emerged as amongst the most controversial holdings by mutual funds. Furthermore, one of the instruments which led to the unraveling of the sub-prime crisis was the asset backed security.