A Primer on the Different types of Debt Mutual Funds

Are you scared of investing in mutual funds because it invests in the equity markets? Most of us assume that investing in mutual funds is akin to investing in the stock market. However, that is not the case. There are mutual funds that do not invest in equities. Debt mutual fund, a category of mutual fund invests in the debt securities issued by the government and various companies.

Debt is an asset class which is less volatile than equities. Government bonds, state development loans, treasury bills, corporate bonds are some of the types of debt instruments.  These debt instruments come with different maturities and risk.

Debt mutual funds invest in these securities according to the scheme’s investment objectives. Based on the underlying securities, debt funds can be segregated into a few categories. Depending on the time horizon, investors can choose the debt funds based on the maturity periods of the papers held by these funds. Different debt funds are meantfor different investors.

Here are some of the main types of debt funds:

Liquid Fund: Liquid Fund carries the lowest risk among the different mutual fund categories. It has the lowest risk as it invests in high-quality debt papers that mature within 91 days.

The main objective of liquid funds is to provide liquidity. It helps investors to park surplus cash for certain period and receive better returns than savings account. Unlike fixed deposits, liquid funds do not have any maturity period. You can also redeem money from liquid funds instantly. Currently, investors can redeem up to Rs.50,000 or 90% of the total amount, whichever is lower, instantly.

Also, in view of the series of downgrades and defaults, the market regulator has laid down stricter norms for liquid funds. According to the new guidelines, liquid funds have to invest at least 20% of their portfolio in liquid assets such as cash, government securities, treasury bills and repo instruments. Moreover, liquid funds can now invest only up to 20% in a single sector and not more than 10 per cent in housing finance companies.

Liquid Funds are good investment option for your short term goals such as planning for a vacation or saving money for a new laptop.

Overnight Funds:As the name suggests, these debt funds will invest in overnight securities that mature in one day. It can be a good investment option for individuals who want to park their money for a day or two.

Money Market Funds: Money Market funds will invest in money market instruments with a maturity period of within 1 year. Money market instruments include

Duration Funds: These debt funds invest in debt securities with a maturity period. Ultra-short duration funds, low duration fund, short-duration fund, medium duration funds, medium to long-duration funds and long duration funds are the different categories of duration funds. Ultra-short duration fund will invest in debt securities with a maturity between three months to six months.  Low duration fund, short duration fund, medium duration funds, medium to long duration funds and long duration funds will invest in papers maturing six to12 months, one year to three years, three years to four years, four to seven years and greater than seven years respectively.

Duration funds will help you to invest in a fund based on your time horizon. E.g., if you are planning for a vacation in the next six to 12 months, you can invest in a low duration fund.

Dynamic Bond Funds

While the duration funds invest in papers with a fixed maturity period, dynamic bond funds can invest in papers maturing at different time periods. The average maturity of the papers of these funds will depend on the interest rate scenarios. If the fund manager believes that the interest rate is likely to inch lower, they will increase the allocation of the long term bonds such as government bonds and vice versa.

Corporate Bond Funds

Corporate bondfunds primarily invest in high rated corporate bonds. Corporate bonds are issued by various companies. According to the recent SEBI guidelines, corporate bond funds have to invest nearly 80% of their portfolio in AAA-rated corporate bond funds. Corporate bond funds carry higher risk than ultra-short and short term funds and hence it is suitable for investors who can take higher risk.

Credit Risk Funds

Credit Risk Funds mainly invests in debt securities that are rated AA by various agencies. Fund managers invest in lower-rated papers that are likely to be upgraded in the future, which increases the value of the paper. As it invests in lower than AAA-rated papers, credit risk funds also have the potential to give higher returns than other debt funds. However, it also comes with higher risk as well. 

Gilt funds       

Gilt funds only invest in government securities of different maturities. Gilt funds perform well when the interest rate is moving south.Investors who want to invest for the long run can invest in these funds. It also comes with higher risk than short term debt funds.

Conclusion:

If you are looking for a tax-efficient investment option that carries lower risk, debt funds can be a good investment option. However, as discussed above, different categories of debt funds carry different risks. So, research is highly recommended before investing in debt funds. In case of further queries, you can always reach out to your financial advisor.