Evaluating Debt Funds: Understanding Types of Debt Funds and the risks involved

Debt funds are mutual funds where the underlying assets are fixed-income securities that could range from bonds, treasury bills, Government Securities and money market instruments.

There are different types of Debt Funds in mutual funds: overnight funds, liquid funds, ultra-short duration funds, short-duration funds, corporate bond funds, credit risk funds, gilt funds, fixed maturity plans, long duration funds and dynamic bond funds. Debt Funds are relatively less volatile than equities. However, they are subject to different risks. Credit and interest-rate risks are the primary types of risk in debt funds. Credit risk is the risk of default of the issuer of the security in repaying the principal and/or interest, it occurs, for example, when  a MF scheme invest in low-credit quality bonds that carry high credit risks. An interest rate risk is when the bond prices fall due to an increase in the rates of interest, thereby exposing the investor to losses. To avoid interest rate risk, investors can consider short-duration funds or liquid funds. To avoid credit risk, investors can consider high-rated corporate bonds or gilt funds that invest in government securities.

Let us understand in detail the different types of debt funds in India:

  1. Overnight Funds
    Overnight fund is a type of debt fund that Investment in overnight securities having maturity of 1 day.. These funds are often considered safe investments given the short duration, where interest fluctuations are minimal.
  2. Liquid Funds
    Liquid fund is a type of debt fund that invests in instruments with a maturity period of less than 91 days. These funds are ideal to park one’s emergency funds as they are liquid and can be redeemed as per need.
  3. Ultra Short-Duration Funds
    Ultra Short-Duration Fund is a type of debt fund that invests in debt and money market instruments such that the Macaulay duration of the portfolio is between 3 months – 6 months.. Such funds carry a relatively lower interest rate risk than long-duration funds.
  4. Short Duration Funds
    Short duration fund is a type of debt fund that invests in debt instruments such that the Macaulay duration of the portfolio is between 6 months- 12 months . these funds are typically not subject to high-interest rate fluctuations.
  5. Corporate Bond Fund
    Corporate Bond Fund is a type of debt fund that invests at least 80% of their corpus in the highest-rated corporate bonds.. However, investor need to assess the credit risk associated with downgraded ratings.
  6. Credit Risk Fund
    Credit Risk Fund is a type of Debt fund that invests 65% of its assets into debt instruments rated below the highest credit quality. Unlike other types of debt funds that are focused on determining the duration, these funds vary their proportion in high interest yielding low-rated bonds. Hence, they may be relatively riskier than other debt funds.
  7. Gilt Funds
    Gilt Fund is a type of debt fund that invests at least 80% of their corpus in government securities (G Secs) across maturities. They carry relatively low credit risk.
  8. Fixed Maturity Plans (FMPs)
    Fixed Maturity Plans is a type of close-ended debt fund that can only be invested in the initial offer period. They are locked in for a specified tenure.
  9. Long Duration Funds
    Long Duration Fund is a type of debt mutual fund that invests in long term instruments that includes G Secs, Bonds, Debentures etc, such that the Macaulay duration of the portfolio is greater than 7 years.
  10. Dynamic Bond Funds
    Dynamic Bond Fund is a type of debt fund that invests in instruments varying across different issuers and maturity periods. Depending on the environment, the fund manager takes a call to vary the duration/ credit risk depending on the fund’s objective.

By investing in debt fund which is invested in high credit quality instruments and investing in short duration, an investor can potentially reduce interest rate and credit risk. Longer duration funds can be opted for depending on the risk appetite and duration of the investment.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.