Types Of Debt Mutual Funds You Need to Focus On

Padmaja Choudhury   /   April 27, 2022
Types Of Debt Mutual Funds

There are several types of debt mutual funds. Let’s see the few important debt fund types.

Currently, most Indian households prefer to invest in mutual funds as it is easy to invest in and has the potential to generate wealth. With different types of mutual funds schemes available, it gets difficult to decide which one to choose. Among equity, debt and hybrid mutual funds, debt mutual funds hold a significant position as these are considered relatively safe investments with high returns in India. However, not all debt funds are similar. There are different types of debt mutual funds that invest in various types of debt investments. This article will look at some of the important debt funds types.

What is a debt mutual fund?
A debt fund is a mutual fund scheme that invests in fixed income or debt securities such as corporate, government bonds and money market instruments that offer capital appreciation and capital protection.

Relatively stable returns, an easy withdrawal process, and decent safety are just a few of the primary benefits of investing in debt funds.

Debt funds are great for investors who want a steady stream of income but don’t want to take higher risks. Debt funds are less riskier than equities funds since they are less volatile.

What are the advantages of investing in debt mutual funds?
Lower volatility: Debt mutual funds are relatively less volatile than other types of mutual funds, such as equity funds, in the short term. Hence, debt funds are better investment options for parking money for the short run or achieving short-term financial goals.

Portfolio diversification: Debt funds help to diversify a portfolio that is heavy in equity. Investments in debt funds can help reduce risks and optimise returns.

Higher returns than traditional saving options: Debt schemes have the potential to generate higher returns than traditional saving options.

Different Types of Debt Mutual Funds
With many debt fund types, choosing the right fit for you will depend entirely on your goals. Here are some of the few debt fund types.

Types Of Debt Mutual Funds

Liquid Funds
Liquidity refers to the feasibility of converting an asset into ready cash. Liquid funds are debt funds that invest in debt securities that mature within 91 days. As the maturity period is short, the underlying instruments are not heavily impacted by the changes in the RBI’s rate. Currently, fund houses offer instant redemption of up to Rs. 50,000 or 90% of the fund’s overall value from liquid funds. Hence, liquid funds are a good option to park money for emergencies.

Gilt Funds
Gilt funds are one of the debt fund types that invest most of its investible money across government securities with varying maturity periods. These are usually considered safe due to no credit risk. However, changes in the RBI repo rate can significantly affect the returns of gilt funds.

Ultra-short duration funds
Ultra-short duration funds are fixed income mutual funds that invest in debt and money market assets with a Macaulay duration of 3 months to 6 months. These funds are better suited for short-term investments since they are less volatile and strive to create more consistent income.

Ultra-short duration funds are different from liquid funds. Liquid funds invest in money market securities with a 91-day maturity, whilst ultra-short duration funds have a Macaulay duration of 3 to 6 months.

As a result, ultra-short duration funds seek to provide better returns than liquid funds. However, as the underlying securities of ultra-short duration funds have a longer maturity period, these funds might be slightly more volatile than liquid funds. As a result, ultra-short duration funds require longer investment tenures.

These funds are best suited to conservative individuals who can commit to investing for at least three months and up to one year.

Short Duration Funds
Short-duration funds are debt mutual funds that invest in debt and money market assets so that the Macaulay duration of the fund is between one to three years.

These funds’ goal is to make money by accruing over the time that the instruments in the scheme portfolio are in the scheme’s portfolio.

The interest rate risk with these funds is minimal. Depending on the credit quality of the underlying instruments, the credit risk of short-term funds might vary from scheme to scheme.

Short-term debt fund managers often keep the underlying instruments in the scheme’s portfolio until maturity, earning coupons or interest income. This is referred to as an accrual-based method.

Though interest rate variations, whether positive or negative, affect bond prices, they do not affect the return on investment if bonds are kept until maturity since the fund will get the principal amount. To prevent interest rate risk, you need to ensure your investment durations match the fund’s Macaulay duration.

Long duration debt funds
These debt funds types invest funds in securities with maturity periods of more than seven years. Since the maturity period is highest among the ones mentioned above, the risk factor gets higher and returns too.

Corporate Bond Funds
A corporate bond fund is a type of debt fund that invests at least 80% of its money in companies with the best credit rating, i.e. AAA. Highly rated companies are generally well-funded and have a good chance of paying back their lenders, such as a fund house, on time.

Credit risk funds
Credit risk funds are for investors with higher risk tolerance as they invest in high-risk and lower credit-rated instruments. At least 65% of funds’ assets are invested in corporate bonds rated AA or below. These funds have the potential to generate higher returns, but it also comes with higher risks. So, if capital safety is your main concern, you can skip credit risk funds. However, if you are willing to take the risk, you can invest a small portion of your portfolio in credit risk funds.

These Types Of Debt Mutual Funds are an excellent way to generate income and, at the same time, participate in the debt market. You can choose a type of debt mutual fund as per your goals, risk tolerance and investment horizon. We hope that we were able to clarify your doubt regarding ‘what is debt mutual fund’ and types of debt investments.

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