A debt fund, is a type of mutual fund that invests primarily in debt instruments, such as corporate bonds, government securities, and treasury bills. Debt funds are generally considered less risky than equity funds and are suitable for investors seeking stability and lower volatility.
Debt funds are investment instruments that have 5 features –
Low risk
High assured returns between 7 to 8 % (which are not dependent on the market)
High liquidity (you can take your money out when you need it)
Low volatility (as it’s not market dependent and returns are mainly fixed)
High benefit in taxation.
Unlike equity mutual funds that invest money in stocks and shares, debt funds are mutual funds that invest your money in fixed-income securities for which interest is gained.
Simply put, you can think of a debt fund as a loan that you give to a company, institute or the government on which you receive fixed interest – meaning, you make money on it.
Debt funds can help diversify an investor’s portfolio by investing in different types of assets. If one type of asset (e.g., corporate bonds) is performing poorly or has become too risky for investors to consider investing in anymore, then the investor may switch to another type (e.g., junk bonds).
This diversification helps reduce risk and increase potential returns for investors who choose to diversify their portfolio by investing in debt funds rather than holding all their investments in one particular asset class such as stocks or bonds alone.
Benefits of Investing in Debt Funds
Higher Interest
Rates
Source of Income
Lower Risk
Diversification
Tax-efficient
Types of Debt Funds
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Overnight Funds
Overnight funds are investment instruments that provide investors with the opportunity to earn a return on their idle cash. It is a type of mutual fund that invests in debt instruments with maturities of one day or less.
Overnight funds are best for businessmen or entrepreneurs who frequently need to store significant amounts of money for only a brief period until it can be used for other purposes.
Overnight funds are managed by professional fund managers who use their expertise and market knowledge to generate returns for investors. Securities in these funds mature the next day, meaning these funds are less exposed to interest rate or default risk in comparison to other debt funds. Of course, this low-risk profile also means they tend to offer the least return.
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Liquid Funds
Liquid funds are debt mutual funds that lend money to companies for up to 91 days. They are considered much safer than other types of mutual funds because of their very short lending duration. Liquid funds are ideal for people who want to save money for emergencies, as there is almost no risk of loss if the investment is held for at least one month.
Liquid funds are a good choice for those who have a lot of cash lying around that they aren't investing anywhere and who want a short-duration investment option with lower risks.
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Ultra short-term funds
Ultra-short-term funds are mutual funds that invest in debt instruments with maturities of up to one year. The main advantage of investing in ultra-short-term funds is that they offer high returns with low risk. This is because these funds invest in highly rated debt instruments that have a low probability of default.
Another advantage of investing in ultra-short-term funds is that they provide liquidity. This means that you can easily withdraw your money when you need it.
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Low Duration Funds
Low-duration funds are debt funds that allow you to invest your money in short-term debt securities that come with an average duration of 6 to 12 months. While this may sound similar to liquid funds, these low-duration funds come with a higher credit risk because they usually hold assets of lower credit quality. This means that they have a higher interest rate and credit risk.
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Money Market Funds
Money market debt funds, or money market funds as they are also known, offer investors access to short-term debt instruments. These investment products have a very low-interest rate, typically below 4% per annum.
The main benefit of investing in a money market fund is its low fees and charges. This makes them suitable for individuals who want to invest their savings and are not interested in the long-term benefits of an equity investment.
Investors can buy units through an online broker or a stockbroker, who then holds the assets on their behalf until maturity. The unit's value will increase with the economy's growth and the issuer's performance.
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Short term funds
Short-term funds are a good option for investors who want to earn regular income without taking on too much risk.
Short-term bond funds invest in debt instruments with maturities of up to three years. The fund managers invest in a variety of debt instruments such as government securities, corporate bonds, and treasury bills. The main benefit of investing in a short-term bond fund is that it offers relatively high liquidity compared to other fixed-income options such as long-term bonds or FDs (fixed deposits).
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Medium Duration Funds
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Medium to Long Duration Funds
Medium to long-duration debt funds invests in securities with a maturity period of 4 to 7 years. Such funds carry high-interest rate risk, and can be a good choice when the economy is doing well, and the interest rates are falling.
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Long Duration Funds
Long-duration funds are mutual fund schemes in long-term government bonds and other debt instruments with maturities of 10 years and above. The primary objective of these funds is to generate income for investors through interest payments on the underlying investments.
Long-duration funds are relatively less volatile than other debt mutual fund schemes, making them ideal for risk-averse investors seeking stability in their portfolios. However, these funds also come with certain risks, such as the interest rate risk associated with long-term bonds. Nevertheless, long-duration funds can be a valuable addition to any investor’s portfolio, especially if held for the long term.
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Dynamic Bond Funds
As the name suggests, dynamic bond funds are the funds in which your fund manager keeps changing your portfolio based on the fluctuating interest rate. Dynamic bond funds can have different maturity periods because they usually invest in instruments of both longer and shorter maturity periods.
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Corporate Bond Funds
Corporate bond funds are like the debtors with the best possible credit rating. Companies with this high of a rating are financially strong and have a high probability of being able to pay back their lenders on time. These types of funds are ideal for people who don't need the money for at least 2 to 3 years. They often times outperform bank fixed deposits that have similar durations, and if you hold them for three or more years, you get tax-efficient returns since they qualify for indexation benefits.
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Credit Risk Funds
A Credit risk funds are designed to take on higher levels of risk than other types of funds. The goal is to maximise your return while minimising the amount of credit you need to invest. These funds invest in debt securities of companies with a lower credit rating. Credit risk funds invest in subprime and leveraged loans, which are secured by collateral such as real estate, vehicles and other assets. These loans are more likely to default than companies with better ratings.
The main advantage of investing in credit risk funds is that it provides diversification benefits over standard bond funds. It also offers the opportunity to earn higher returns than fixed-income investments such as bank deposits and cash reserves.
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Banking and PSU Funds
Banks and public sector undertakings (PSUs) are the two most important types of investment funds. Banking debt funds invest primarily in medium-term time deposits with banks. Time deposit refers to money deposited for a specific period of time at a fixed interest rate that does not change after it has been deposited. This means that even if interest rates go down, your money will still earn the same interest rate until the maturity date of your deposit note.
On the other hand, PSU bond funds invest primarily in short-term notes issued by the government or public sector enterprises (PSEs). Both types of debt funds have their benefits but may not be suitable for everyone.
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Gilt Funds
Gilt funds are a type of debt fund that invest in gilts or bonds issued by the government. Gilt funds typically invest in various gilt issues and can be used to help diversify an investment portfolio. They have the advantage of being relatively low risk and are suitable for those with a limited appetite for risk but still want to participate in the equity markets.
Gilt funds are generally very liquid funds with regular reviews and trade throughout the day on a secondary market. They can also be bought and sold directly from your broker's website.
Gilt funds are usually considered appropriate for investors with moderate risk tolerance and various bonds available to suit your requirements.
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Gilt Funds With 10-Year Constant Duration
Investment vehicles that invest in securities by the Reserve Bank of India are known as the Gilt Funds. As the name suggests, a gilt fund with a ten-year constant duration comes with a fixed maturity period of 10 years, and it is meant for people who have lower risk tolerance.
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Floating Rate Funds
Floating rate funds have a floating rate of interest. This means that the interest paid by the fund is never fixed. Instead, it changes according to market conditions and other factors. Floating rate funds are popular because they offer the flexibility to invest in a wide range of investments without any restrictions on their interest rate.
The main benefit of floating rate funds is that you can use them for short-term investment purposes. This means you can use them for saving or even investing in emergency funds.
Things to Consider Before Investing in Debt Funds
Debt funds are a good investment if you have a cash surplus, but there are some things to consider before investing in debt funds. Many factors can affect the value of a debt instrument and its interest rate.
The riskiest debt instruments tend to be government bonds, which often have negative real yields (the return on an investment minus inflation). However, there are a number of other risks that investors take when investing in debt funds:
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FAQ
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