Which is the most suitable type of Debt Mutual Fund for you?

Introduction

It is no secret that stock markets can be volatile. Even the most stable of stocks wobble with their price movements at times. So how do you get the much-needed stability in your portfolio? Is there any scope of fixed regular income from capital markets? Well, there is! The answer to your worries is Debt Mutual Funds. Despite the fact that it is not risk-free, it presents a comparatively lower risk.

So, here’s all there is to know about Debt Mutual Funds.

What is a Debt Mutual Fund?

Debt Mutual Funds, as the name suggests invests the fund corpus in debt instruments to extract gains. Now, these debt instruments earn interest income and sometimes capital gain for you. Examples of such instruments are corporate bonds, treasury bills, government securities, commercial papers, money market instruments, etc. Each of these instruments comes with a pre-decided interest rate and maturity date. So, an investment in these securities opens doors to a fixed interest payout and principal amount if held till maturity. Hence, debt instruments are also known as fixed-income securities. However, if a bond is sold before maturity, it may lead to capital gain/loss as the bond price fluctuates as per the market's prevailing interest rate. For example, if the market interest rate is lower than the bond's coupon rate, the bond will trade at a premium and may lead to a capital gain if sold before maturity. Conversely, if market interest rates are higher than the bond's coupon rate, it will trade at a discount in the market and may lead to a capital loss. Since debt instruments have pre-decided interest rates, there is no scope for fluctuating interest income from these investments. Hence, they are relatively less risky than stocks and other equity-linked securities. Such funds are ideal for you if your risk appetite is low.

Additional Read: Four benefits of investing in debt mutual funds

Understanding the risk-return quotient associated with Debt Funds

A recurring question by many investors is about the risks and returns of debt funds. If debt instruments generate fixed income for you, how is it risky then, you may ask?

Well, when your fund invests in debt instruments, it is lending your money to public, private, and government companies for their growth at a fixed interest rate. If any such company defaults on loan repayment, your principal amount and interest income fall in jeopardy. This is why each of these instruments is given a credit rating from authorized credit rating agencies. A high rating means low defaulting risk and vice-versa. You can gauge the associated loan defaulting risk through such credit ratings.

Typically, debt instruments with low credit ratings come with high-interest rates. Conversely, those with high credit ratings offer low-interest income. The maturity tenure of the instrument also has a directly proportionate effect on the risk of these funds. Hence, the fund manager of your debt fund scheme has to take calculated risks using these credit ratings and maturity periods to select the right blend of debt instruments for the scheme’s portfolio. The end objective of your fund manager is to generate returns at par or above the benchmark level of the scheme.

Additional Read: New risk matrix to classify Debt Mutual Funds

Types of Debt Mutual Funds

Debt Funds can be classified into the following different types based on the maturity and duration of the securities they can invest in. The duration of debt securities is directly proportional to the debt securities' maturity.

Overnight Funds

These funds are one of the safest of the lot as they invest in securities like money market instruments that have only a day-long maturity. The credit risk these funds carry is almost nil and the interest rate offered is also negligible. Invest here if your objective is liquidity and not high returns.

Liquid Funds

The assets in these funds' portfolios include debt securities that mature in less than 91 days. Such funds offer low but stable returns. Invest here if you want a safe avenue for depositing your surplus funds for a short to medium tenure.

Additional Read: Liquid Debt Funds in India - All You Need to Know

Ultra-short Duration Funds

These funds come with a low-risk quotient and offer marginally higher returns than Liquid Funds. These funds invest in debt securities that have a duration of three to six months.

Additional Read: Basic Features and Benefits of Ultra Short-Term Debt Funds

Low Duration Funds

The risk quotient of Low Duration Funds is slightly higher than ultra-short duration funds. These funds invest in debt securities that have a duration of six months to a year.

Short Duration Funds

The underlying assets of these funds are a mix of securities whose duration ranges from one to three years. Hence, these funds best deliver gains if you have slightly higher risk appetite.

Medium Duration Funds

Medium duration Funds invest in debt securities that have a duration from three to four years. They are comparatively more risky than the short duration funds

Medium - Long Duration Funds

This fund invests in securities with duration ranging between four and seven years. Invest here if you have seek moderate to high returns from your investment and have similar risk appetite.

Long Duration Funds

These funds invest in debt securities that have a duration of more than seven years. They carry significant interest rate risks. Such funds tend to perform well when interest rates are falling.

Dynamic Funds

Dynamic Funds are moderately risky investments that come with no pre-set conditions about the underlying securities or the maturity period of the fund. They invest in different debt securities with varying maturity durations as per the market condition and interest rate cycles. An ideal investment tenure for such a fund may be three to five years.

Floater Funds

Floater Funds invest at least 65% of its assets in debt instruments with floating interest rates. Since the fund aims at selecting securities where interest rate is tied up with some benchmark like repo rate, etc., this fund carries low-interest rate risk.

Money Market Funds

This type of debt fund invests its assets in money market instruments that mature maximum in a year. The risk-return profile is low to moderate in such schemes.

Corporate Bond Funds

These funds invest over 80% of their corpus in corporate bonds with a highest credit rating. Investments here keep your principal secure and offer regular interest income too.

Credit Risk Funds

Credit Risk Funds invest a minimum of 65% of their corpus in corporate bonds that carry a credit rating of AA. The low credit rating of the underlying securities associates a higher default risk to these funds.

Fixed Maturity Plan Funds (FMP)

Fixed Maturity Plan Funds are close-ended schemes that come with a lock-in period. The maturity duration of the fund’s underlying debt securities matches the lock-in period of the fund. The interest rate is pre-decided and usually securities are held till maturity in such schemes, so there is no interest rate risk. The lock-in period assigns a low-liquidity quotient to the fund.

Banking and PSU Funds

Banking and PSU Funds invest a minimum of 80% of their corpus in debt securities issued by Public Sectors Units, Public and Private Banks, and other financial institutions. Such funds are moderately risky. They create a fine balance of investment risks, returns, and liquidity concerns. 

Gilt Funds

Gilt Funds are one of the safest debt instruments to park your funds as they primarily invest in government securities. There are no defaulting risks associated with this fund type. These funds invest across maturities..

Conclusion

Debt adds a sense of security to your investment portfolio. It is an intelligent solution to minimize risks. And the umpteen types of debt funds coming with varying risk-return combinations offer a broad enough range to choose from, depending on your end goals. But truth be told, long-term investments in debt instruments may not fetch you returns as high as equity investments could. So, to create the perfect balance of adequate safety threshold and desired returns in your portfolio, you could park your funds partly in both these avenues in a ratio such that it appeals to your risk-return profile and fulfils your financial objectives.

Additional Read: How to Choose the Best Debt Mutual Fund?

Additional Read: How to Build a Stable Debt Portfolio?

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Please note that Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. I-Sec does not assure that the fund's objective will be achieved. Please note. NAV of the schemes may go up or down depending upon the factors and forces affecting the securities markets. Information mentioned herein is not necessarily indicative of future results and may not necessarily provide a basis for comparison with other investments. Investors should consult their financial advisers if in doubt about whether the product is suitable for them.

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