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Understanding bond funds and liquid funds

Monday, July 25, 2016
By I. V. Subramaniam

I. V. Subramaniam Director - Quantum AMC and  MD & CIO- Quantum Advisors

I have SIPs which I expect will average out market high/lows. However, I got surplus fund and I want to invest that. As per my asset allocation I have too much exposure to debt and every new investment should be in equity/ equity based MF. But at this market high I am confused if it would be wise to enter equity market now?
     —Swati Jain, Malad

I am impressed with your asset allocation plans and steps you take to achieve those plans. Since your asset allocation suggests that you need to increase your exposure to equities, you should have a plan to implement it. Therefore on your additional investment-

One method to mitigate the risk of investing in a market which has moved up sharply in the last few months is to do a Systematic Transfer Plan (STP). You can park your additional amount in a liquid fund and then transfer every month through STP into equity fund.

Since you are underweight equities, I do not see any reason to book profits in equities. You should look at your entire portfolio to decide if any specific amount needs to be moved into fixed deposit for meeting a specific financial goal.

I have no idea about the break-up of your debt exposure. If the debt exposure is through bond funds or liquid funds, you can think of moving some money out of these funds into fixed deposit in order to meet your goals. However, when you are reallocating from liquid/bond funds into fixed deposit, please also look at your taxation impact.

I would like to understand bond funds and liquid funds
—Dheeraj Thakkar, Parel

Understanding bond funds and liquid funds

  • These funds invest in fixed income securities. The securities may have a maturity date which ranges from 30 days to 30 years. Liquid funds invest in shorter maturity securities. By law they cannot invest in securities with more than 91 day maturity.
  • These funds earn interest income.
  • When interest rates move up, the bond prices go down.
  • When interest rates move down, the bond prices move up.
  • Generally, if the duration of the underlying instrument is long, the bond prices movement will be more sensitive to the duration of the instrument. For e.g. When interest rates move up the price of bond funds in which the instruments are of longer terms will decline more than funds in which the instruments are of shorter terms. Vice versa when interest rates move down.
  • Therefore liquid funds may generate less return but they are usually less volatile as they hold instruments which are of very short term.

Nevertheless, as such, liquid funds are not a very attractive proposition for non resident Indians as the alternatives of liquid funds – NRE or FCNR fixed deposit – are clearly more beneficial as the interest income from these deposits are exempt from taxation.

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