What are Debt Funds? What are the different types of Debt Funds?

Published On: 19-Dec-2021

Debt funds are one of the five broad categories of mutual funds allowed by the Securities & Exchange Board of India (SEBI). Debt funds predominantly invest in debt securities and bonds. Such securities tend to provide income primarily through interest income from such securities.

Thus, investors prefer debt funds for portfolio stability coupled with reasonable returns to the investors. However, investors must note that even the debt funds are subject to inherent risks like interest rate, credit, and liquidity risks. However, the extent of such risks varies according to the different sub-categories of debt funds.

Interest rate risk refers to the sensitivity of the debt portfolio to the changes in market interest rates. The valuation of debt securities is inversely proportional to the interest rate movements, i.e., the valuation rises when the interest rates decrease.

In contrast, the valuation lowers when the interest rates are rising. Debt funds may manage the interest rate risk by managing the fund duration, i.e., the average period the debt security will carry the fixed coupon, and investing in floating rate instruments.

Similarly, credit risk refers to the risk of the issuer entities defaulting on the debt servicing obligations. Such risk is gauged through the credit ratings of the issuer entities. The funds may manage the credit risk of the mutual fund scheme with an optimal balance of credit ratings and portfolio returns.

When the credit risk improves with an upgrade in credit ratings, the existing debt securities becomes more attractive with better credit spreads. Similarly, the investors may be at risk of generating negative returns due to the markdown in portfolio valuation, in case the credit rating is downgraded.

Liquidity risk refers to the risk of not being able to liquidate the investments at their fair value, as and when required. If the fund liquidates the assets at a lower value than the fair value, the difference is called impact cost. The fund may mitigate such risk by maintaining an optimal proportion of liquid investments, etc.

Types of debt funds:

Overnight and Liquid Funds

An overnight fund invests in securities with one-day maturity only. In contrast, a liquid fund invests in debt and money market securities with a maturity of up to 91 days. Due to the lower tenor and investments predominantly in sovereign securities, such funds tend to stay insulated from interest rate and credit risk.

As such, these funds remain suitable for maintaining emergency fund corpus for contingent needs.

Duration funds

Such funds invest in debt securities with different durations, and different types of duration funds are classified based on the targeted duration of such a mutual fund scheme. Examples of such funds are ultra-short duration fund, short-duration fund, dynamic bond fund, etc.

Investors can manage the interest rate risk in their investment portfolio through duration funds. In the case of decreasing interest rate scenario, investors may like to invest in long-duration funds, while short-duration funds may be more suitable in increasing interest rate scenario.

Gilt funds

Gilt funds invest a minimum of 80% of its net assets in Government Securities (G-Secs). With predominant investment in sovereign securities, gilt funds help the investors to mitigate credit risk. However, depending upon the fund duration, the investors may be exposed to interest rate risk.

Credit Opportunities Funds

Such funds aim to generate better returns for the investors by benefiting from the different credit spreads for different credit ratings. Such funds include Credit Risk Fund, Corporate Bond fund, Banking & PSU fund, etc.

Fixed Maturity Plans (FMPs)

These funds have a fixed redemption date. As such, the fund managers generally tend to match the investment duration with the fund maturity.

With different types of debt funds available, the investors may consider investing in the debt fund which best suits their risk appetite, financial goals, and investment horizon.