What are the Types of Debt Funds | Mutual Funds

We have seen a good amount of information on mutual funds which are available for investment in India with great returns. Investment in equity mutual funds is always for the longer term. There are other funds called as debt funds which are best options for the short duration. For a complete well-diversified portfolio make sure to add few debt mutual funds too. Let’s see these debt mutual funds in detail in this post.

What are debt funds

Companies borrow for various purposes – to meet working capital requirements, for capital expenditure, to fund expansion, and so on. Similarly, the government also borrows for its spending needs. These entities issue instruments for these borrowings – bonds, treasury bills, commercial papers, debentures, certificates of deposits, and such.

These debt instruments carry a particular interest rate and maturity period. They are also called fixed income instruments. Maturities can be the range from a few days to few months to a few years. In government securities, it can go up to several years. Typical instruments are less risky than long-term ones for the simple reason that the contingencies linked to a company’s fundamentals are higher over the long-term.

Debt investments carry 2 types of risks. The first one is that interest rates change over time. If interest rates move lower, new debt instruments issued will consequently have lower interest rates. But then the traditional instruments that are already issued still carry the past interest rate. They, however, adapt to the new interest rate situation by way of change in their price. Therefore, the bond prices traded in the market move in line with the change in interest rates. This relation is captured by what is called the ‘yield’ of the bond.

The second risk is that the borrower defaults on payments. Organizations are graded on their credit-worthiness or their ability to meet interest and principal repayment commitments on time. This grade is termed its credit rating. A high credit company is trustworthy than a low-quality one, and will, consequently, pay a lower interest rate. While risk is higher in a poor-quality firm, rates are also higher as it is made to pay a bigger price in order to borrow.

Debt fund types

Debt mutual funds invest in a mixture of debt securities – short or long term, corporate bonds, bank debt, gilts, high-quality papers, low-quality papers, secured and unsecured bonds, and so on. There are, at all times, several instruments to invest in with varying interest rates and maturities. Debt funds actively balance these instruments in their portfolio based on the interest rate movement to deliver returns. The kind of debt fund it is depends on the average maturity of the instruments in its portfolio or then the type of strategy the fund follows. The longer the maturity period is, the greater the risk, and thus higher the return.

Liquid funds –

These funds hold instruments of extremely short maturities. By rule, they cannot invest in instruments whose maturities are higher than 91 days. Generally, liquid funds hold instruments that mature in a matter of days. These can be commercial papers issued by companies (called as CP), certificate of deposits issued by banks (called as CD) or government treasury bills. These are collectively called money market instruments. Liquid funds also stick to instruments of the biggest credit quality.

The short nature of these instruments, great quality, and very less volatility in their NAV make them extremely safe investments. These funds do not have any exit loads, and you can redeem your investments very quickly in these funds. Due to these reasons, liquid funds are the perfect option to savings bank accounts, which carry the lowest interest rates. Money left idling in your savings bank account; therefore, it can be shifted into liquid funds to get bigger returns.

See more – How to Choose the Best Mutual Fund on Your Own

Ultra short-term funds –

These funds are one step above the liquid funds regarding the maturity of the instruments they usually hold. That is, while they hold CD’s and CP’s, they go for a bank or corporate bonds that are a bit longer in term in nature of up to one year, or maybe a bit longer. Therefore, they need a holding period of around a 1 year. Currently, the average maturity period of ultra short-term funds is approximately around 9 months. Most of the ultra-short term funds invest in a high-quality credit. They are good parking grounds for excess money that you don’t need instantly but may require a little later on. They deliver higher returns than liquid funds.

debt funds

Debt Fund-Risk Return Graph

Short-term debt funds –

These funds go for longer maturity periods than ultra-short term funds. They invest in corporate bonds to a greater degree and rely very less on CD and CPs. These funds may also have some holding in short-term government securities. Average maturity periods of the portfolios will typically be around two years or a maximum of three years. They require a holding period of about two to three years.

Long-term debt funds –

These funds invest in long-term debt of 3 years and more. Long-term debt funds require holding periods of at least 2-3 years and should form a part of every long-term investment portfolio. You can think of both short-term and long-term debt funds as an option to your normal go-to option of fixed deposits.

Short-term and long-term debt funds may take a call to invest in instruments of low credit quality companies. Because such instruments offer attractive interest rates, the portfolio’s yield moves higher and returns jump, though the risk also moves a bit higher. Funds that explicitly follow such a strategy of recognizing companies with poor credit and high-interest rates and lending to them are called credit opportunity funds and they are amongst the highest-risk debt funds.

Some short-term and long-term debt funds are also called income funds due to their investment strategy. These funds retain bonds to maturity and primarily aim at getting interest income across rate cycles. They do not try to forecast or play the interest rate cycle. Such funds fundamentally hold corporate bonds as that’s where rates are higher and variations in bond prices lower.

Gilt funds –

These are the funds that invest completely only in government securities and try to get profit from changes in bond prices as interest rates vary. There can be both short-term gilt and long-term gilt funds. These funds are akin to sector funds in equities; they require careful observing and timed entries and exits and are therefore the highest-risk category of the debt funds.

All the above funds are open-ended debt funds. Apart from this, you also have close-ended debt funds called as Fixed Maturity Plans (FMP), which have a fixed tenure. The tenure can be a few months to a few years for which your investment is locked. These invest in money market instruments, gilts, and bonds. Fixed Maturity Plans usually match the maturity profile of the portfolio to their mandated maturity period.

As explained above, the risk and return levels from highest to lowest are in order of explanation above – gilt, long, short, ultra-short, and liquid.

These funds are very well suited for the short duration compared to bank savings account.  Choose funds based on your risk appetite and expected returns. Note that mutual funds returns are market situation dependant. Take help of your financial advisor to create a portfolio best suited to your requirements.

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