Nowadays, there is awareness among investors to park their money in mutual funds. But, are mutual funds only of one kind? Are they limited only to equities? The answer is no.
One can choose from many kinds of mutual funds based on one’s risk appetite, time horizon, and the kind of asset class one wishes to invest in. While some people with a higher risk appetite would always prefer equities, there may be some who would rather choose an investment option with a lower risk. Here's where debt funds come into the picture. A debt fund is a fund that invests in securities that guarantee you a fixed income, such as treasury bills, corporate bonds, commercial papers and government securities.
Another low-risk investment can be a money market mutual fund. But what exactly are such funds?
A money market fund is a type of mutual fund that invests in high-quality debt instruments, cash and cash equivalents. Such funds are usually for a shorter duration. They generally have a high level of liquidity.
Money market funds are generally considered to be extremely low on the risk parameter. While they may generate income, they offer little capital appreciation. Since they do not qualify as long-term instruments, the average duration of such funds is one year.
These kinds of funds invest in securities known as money market instruments. They are highly liquid and have a high credit rating. Such instruments offer predictable returns and are considered risk-free instruments.
Here are various kinds of money market instruments:
- Treasury bills
Treasury bills, also known as T-bills, are issued by the government. As they carry the sovereign guarantee with them, they are safe and risk-free. The maturity period of treasury bills can range between 91 days (three months) and 365 days (one year). Returns are directly proportional to the level of risk. Since these instruments carry low risk, their returns are also lower.
- Commercial paper
A commercial paper (CP) is a form of unsecured, short-term debt used typically by corporate houses. It is typically used for payroll financing and meeting other short-term liabilities. Maturities on such instruments generally don't go beyond 270 days. They are usually issued at a discount and reflect current market interest rates.
- Repurchase agreements
A repurchase agreement is usually made between a commercial bank and the Reserve Bank of India, or between two commercial banks to facilitate short-term loans. It is also known as a repo loan. Financial institutions under such agreements sell securities from governments in an overnight transaction and agree to buy them back at a higher price at a later date. The security acts as a collateral and the buyer earns interest in return.
- Certificate of deposit (CD)
CDs are offered by banks and credit institutions. The customer gets an interest rate premium in exchange for making a lump-sum deposit for a certain time period. CDs are offered by almost all consumer finance institutions. Unlike a fixed deposit, a CD can be negotiated. The rates of interest are determined by the RBI.
Advantages of money market funds
- Safety
Investors who do not have the stomach for taking risks and want to choose a safer investment option may consider money market funds. The highest rated bonds are usually the ones rated ‘AAA.’ Most companies in India issue AAA-rated bonds. The 'AAA' rating creates a sense of safety in the minds of investors. As compared to equities, they are relatively safer investments.
- Liquidity
This is another key advantage of money market funds. Securities mature in a shorter time frame and can be liquidated for cash.
- Yields
Money market funds may not result in fast growth of the principal invested as they are mandated to keep the net asset value (NAV) of the funds at a minimal level. However, they fetch higher yields as compared to other instruments like cash or cash equivalents.
As a result of the above factors, Money Market Funds can be used as a diversification tool for your portfolio.
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