If you want to protect a portfolio from volatility, you must be careful and cautious on what type of instrument you want to invest in. It must ideally have a perfect balance of equity as well as debt, preferably in equal proportion.
Among all types of debt instruments available, there are a few that you can choose to invest for a regular income. At this point, you must know that debt funds can not only provide high returns on your investments if you are prudent in making the right choice, but it will also provide you with a lot of tax benefits.
Therefore, as an investor, you must know the different types such tax efficient debt instruments and its brief characteristics before you invest. However, you must make your choice based on your investment goals and the investment tenure.
Ideally, most individuals, companies, and governments use the most common types of debt instruments such as loans, debentures, and bonds either to generate investment income or to raise capital.
The most significant characteristic feature of these debt instruments is that it essentially acts as an IOU between the purchaser and the issuer. The lender guarantees the buyer of these debt instruments a full repayment after the specific tenure in exchange for a lump sum payment. The income on these instruments over time comes in the form of interest and depending on the terms of the contract. In the end, these debt instruments result in an accumulative profit for the lender.
Types of debt instruments and its characteristics
As for the types of debt instruments to choose from, you will get:
- Loans – This is the most common type of debt instrument that is most easily understood as well. Most people take out loans at some point of time or the other from financial institutions, banks, and even individuals. These loans can be used for a variety of purposes, no questions asked, provided it is not a specific loan such as a home loan, auto loan or student education loan and even business loan. Such loans are usually simple loans where a borrower is the purchaser and is allowed to take a given sum of money from the lender with a promise to pay it back after some time with interest for the privilege granted. Simple as it may seem, often people fail to continue with the repayment and end up with a more substantial debt to repay it. If you are in such a situation currently, read the debt consolidation review before taking out such a loan.
- Bonds – This is another common type of debt instrument that is issued usually by governments or any business. Investors buy these bonds by paying the issuer a price as per the prevailing market value of each bond. In exchange, they are promised of a scheduled coupon payment for guaranteed loan repayment. Usually, these are a specific type of debt investment in which the assets of the issuer back it. That means you will get repaid as a bondholder from the assets of the company if the company issues these bonds to raise debt capital but declares bankruptcy subsequently.
- Debentures – Often confused with bonds as most people say ‘debentures and bonds’ together, there is a significant difference between the two types of debt instruments. The debentures do not have any asset backing and are often used to raise short-term capital for any specific projects. The debenture holders invest in this project and expect to be repaid from the revenue generated through the particular projects. Typically, debentures are backed only by the general trustworthiness and credit of the issuer and guarantees fixed rates of income just like the bonds.
- Gilt funds – These are funds to invest in all different types of government debts, bonds issued on behalf of the Center by the central bank, as well as bonds issued by the state governments. Usually, these funds are invested in papers that are sponsored by the governments and therefore carry no default risk. However, you must not consider these 100% safe from all aspects as the rate of interest may be a risk and concern. Therefore, stay away from long-term gilt funds as these are the riskiest amongst all debt funds being most sensitive to changes in interest rates.
- Short-term funds – These funds usually invest in commercial papers, Certificate of Deposits, bonds, and other debt securities. These investments typically have a maturity period of 3 to 6 months. As these are not affected by the fluctuations in interest rates, these are safer than gilt funds and promise a consistent return in most of the times. Therefore, if you want to earn some surplus money and invest in something that provides a higher return than liquid funds, then short-term debt funds are ideal for you as an investment for 6 to 12 months horizon.
- Income funds – These are funds that invest in debt instruments such as bonds, government securities, and corporate debentures. Apart from there is a wide range of maturity profiles in which income funds can be invested. These funds have more flexibility and invest in short-term instruments of one or two years or papers of up to 15 to 20 years. These funds make the most of the interest rate movement taking aggressive calls typically.
- Fixed maturity plans – Commonly known as FMPs, these have a fixed tenure just as the name signifies and are invested in papers having the corresponding maturity. Since these are held till maturity, it typically takes away the risk of fluctuating interest rate. The NAV of the fund is unaffected even if the rate of interest moves up. That means, returns from these funds are pretty predictable but not guaranteed.
Liquid funds are the last in the category but not least. Money is invested in highly liquid money market instruments such as commercial papers, Treasury Bills, negotiable Certificates of Deposits and inter-bank call money market. You will get the most stable returns from these among all debt funds. The easy liquidity factor enables it to be used as an alternative for a savings bank account.