Debt funds are a type of mutual fund that generates returns by investing money in government bonds, debt securities, and money market instruments. The returns are usually not affected by fluctuations in the market, which makes debt funds a low-risk investment option. Since debt funds are least prone to market fluctuations, their returns may not be as high as those of small-, mid-, or large-cap funds, but they give nearly steady returns. Investors who are averse to market risks generally opt for debt funds.
Types of debt funds:
There are 16 types of debt funds categorised by the market regulator, Securities and Exchange Board of India (SEBI), on the basis of their risks. Here are the 16 types of debt funds:
Overnight Funds: This debt fund has a maturity period of just one day.
Liquid Funds: These funds invest in short-term money market instruments with a maturity of up to 91 days.
Ultra Short Duration Funds: These funds invest in debt and money market instruments with an average holding period of six to 12 months.
Low-Duration Funds: These funds invest in debt securities with a maturity of up to 1 year.
Money Market Fund: This involves investing in money market instruments with a maturity of up to one year.
Short-Duration Fund: These funds invest in debt and money market instruments with a portfolio duration between 1 and 3 years.
Medium-Duration Fund: These funds invest in debt and money market instruments with a portfolio duration between 3 and 4 years.
Medium to long-duration fund: They invest in debt and money market instruments with a portfolio duration between 4 and 7 years.
Long-distance fund: This category invests in debt and money market instruments with a portfolio duration greater than 7 years.
Dynamic Bond: This type of debt fund helps spread out your investments over a variety of time horizons.
Corporate Bond Fund: Ensure a minimum of 80 per cent investment in corporate bonds with a rating of AA+ and above.
Credit Risk Fund: Ensure a minimum of 65 per cent investment in corporate bonds, but only in those rated AA and below.
Banking and PSU Fund: Invest at least 80 percent of your money in debt instruments such as municipal bonds, PSUs (public sector undertakings), banks, and PFIs (public financial institutions).
Gilt Fund: It needs at least 80 per cent of investments in government securities (G-secs) across various maturities.
Gilt Fund with a 10-year constant duration: Allocate at least 80 per cent of investments in G-secs with a portfolio duration equal to 10 years.
Floater Fund: Allocate at least 65 per cent of investments in floating-rate instruments, including those converted from fixed rates through swaps or derivatives.
Benefits of debt funds: Here are some benefits that debt funds offer
- Consistent interest income and capital appreciation.
- Diversification across a variety of debt instruments helps reduce risk.
- Liquidity allows investors to buy and sell units with ease.
- Since they are less risky than equity funds, debt funds provide a safer option for conservative investors.
- Suitable for those who want investment with short- and medium-term horizons.
How to know the risk of investing?
Though these funds are thought to offer good returns, they also come with risks. So, it’s important to be aware of the risks before making an investment in debt funds.
“The allure of higher returns often comes with higher risks. If one attempts to boost the interest component by investing in lower-rated instruments, it introduces the risk of capital loss in adverse conditions, says Deepak Jain of Edelweiss Mutual Funds.
“Similarly, a long tenure of underlying securities exposes them to valuation risk, as any unfavourable movement in interest rates can lead to a downside in the price,” he added.
Deepak also explains how the bond price can impact interest rates. “The price of a bond is inversely proportional to interest rate movements. An essential risk to be vigilant about is liquidity. Lower-rated instruments may not always provide easy liquidity,” he further said.
What are the risks of debt fund investment?
Debt fund investment also has some risks. Here is the list of those risks in debt funds:
- Interest risk
- Credit risk
- Liquity risk
- Spread risk
- Counterparty risk
- Prepayment risk
- Re-investment risk
Interest risk: When interest rates rise, prices of fixed-income securities fall, and vice versa. This affects the value of a scheme’s portfolio.
Credit risk: It is associated with default on interest or principal amounts by issuers of fixed income securities. Government securities are safer than corporate bonds, which carry higher credit risk.
Spread Risk: Credit spreads on corporate bonds may change, impacting the market value of debt securities in a portfolio.
Liquidity Risk: It refers to the ease of selling securities at their true value. Tight liquidity conditions may lead to higher impact costs.
Counterparty Risk: There is a risk of the counterparty failing to fulfill transactions, leading to potential losses.
Prepayment Risk: It arises when borrowers pay off loans earlier than due, affecting the yield and tenor of asset-backed securities.
Re-investment Risk: There is a risk that reinvesting interim cash flows at lower rates may result in a lower realised yield than expected.
Who should invest, or how should you choose the right one for you?
Deepak Jain also describes that if anyone wants to invest in debt funds, they have to follow this strategy:
Choosing the right funds to invest depends on the person-to-person or individual. If you are a conservative investor, you would prefer to choose a fund with high-quality credit and low maturity.
On the other side, if you are able to take a risk, then choose funds with lower credit ratings, higher maturities, or a combination of both to seek potential higher returns and liquidity challenges.
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