Debt funds are mutual funds wherein the underlying assets are fixed-income securities. Fixed income securities could range from bonds, treasury bills, Government Securities to different money market instruments.
Investing in a debt instrument is similar to lending an advance to the issuing entity. Debt mutual funds aim to provide interest income periodically along with scope for capital appreciation. Such funds invest in fixed-income generating securities and are preferred by individuals, who do not wish to invest in volatile equity markets. The issuer pays a fixed coupon which is known in advance along with tenor which helps a fund manager of the scheme as well as investor to have a fairly decent idea about the likely returns on the money he is planning to invest.
Debt Funds are a category of mutual funds which are professionally managed by a fund manager. The role of the fund manager is to invest in securities that meet the investment objective of the fund. This is achieved by investing according to the credit rating of the instruments and nature of the fund. The credit rating of the issuer helps to determine whether the firm would be able to service interest obligations regularly. The fund manager typically chooses to invest in high credit quality rated g instruments. A higher credit rating means the issuer will be consistent in disbursing interest payments periodically, as well as pay back the principal amount on maturity. By investing in high credit quality instruments, debt funds endeavour to provide safety of principal.
The fund manager also determines the maturity period of instruments held in each portfolio depending on the outlook of the interest rates in the economy. If the interest rates are predicted to fall, the fund manager invests in long-term securities. Instead, if the interest rates are predicted to rise, investments are made in short-term securities.
Overnight funds invest in securities with an investment horizon of one day. Given the short duration, interest fluctuations are minimal. These funds are often considered safe investments.
Liquid funds invest in short term money market securities which maturities of less than 91 days. If you wish to park your funds for a short period bearing little risk then, liquid funds are a good investment option. They typically offer higher returns than regular savings deposits as well.
Ultra Short-Duration Funds
These debt funds invest in debt and money market instruments which mature between 3 to 6 months. They offer higher returns than a fixed deposit. Such funds carry a relatively lower interest rate risk.
Short Duration Funds
Short Duration Funds invest in debt and money market instruments that mature between 1-3years. They are relatively low on risk. Ideal for conservative investors as they typically not subject to high-interest rate fluctuations.
Corporate Bond Fund
Funds that invest at least 80% of their corpus in highest-rated corporate bonds are categorised as Corporate Bond Fund. They offer scope to earn higher returns than those provided by short term debt funds. Though you need to watch out for credit risk associated with downgraded ratings.
Credit Risk Fund
Credit Opportunities fund is a relatively new category that typically invests 65% of its assets into debt instruments rated below highest credit quality. These funds take a call regarding proportion to invest in high interest yielding low-rated bonds, unlike other debt funds that are focused on determining the tenure, or, the average maturity. Hence, they may be riskier than other debt funds.
Funds that invest at least 80% of their corpus in government securities (G Secs) across maturities are called Gilt Funds. The portion invested in Government securities virtually carries no credit risk.
Fixed Maturity Plans (FMPs)
Fixed Maturity Plans can only be invested in the initial offer period. They are close-ended debt funds. They are locked in for a fixed tenure, which could vary from months to years. FMPs tend to offer superior and tax-efficient returns if held for more than three years. However, there is guarantee of consistent returns.
Long Duration Funds
Long Duration Funds are debt mutual funds that are managed actively to generate steady returns over different market scenarios. They mostly invest in long term securities comprising G Secs, Bonds and Debentures. The duration of the fund is longer than seven years.
Dynamic Bond Funds
These funds invest in debt instruments across different issuers and have dynamic maturity periods. They are suited for investors with a moderate appetite for risk and are looking at an investment horizon of between 3-5 years.
You should choose a debt fund depending on the investment tenure you have in mind. If it is a year or less, liquid funds and ultra short-term funds may be suitable. In case of 1-3 years, short-term bonds could be the best option. If you have a medium-term horizon of 3-5 years, corporate bond funds or dynamic bonds could be suitable too. Usually, higher the tenure, more are the returns, except during a rising interest rate scenario.
Choosing debt funds also depends on your overall investment goals. Is it an additional source of income during retirement? Or, is it a safe fund for liquidity purposes? Investors also use debt funds as a means to supplement income over salary.
Debt Funds carry lower risk than equities. However, they suffer from credit and interest-rate risks. If a fund manager were to invest in low-credit quality bonds, then they carry high credit risks. Value of the portfolio may go down due to delay or default in payment of interest and or capital. An interest rate risk occurs when the prices of the bond tend to fall due to an increase in the rates of interest, thereby exposing the investor to losses.
While debt funds are fixed-income securities, they do not guarantee returns. The net asset value of debt funds is linked to the overall interest rates in the economy. The value of such funds tends to fall with rising interest rates. They are therefore more suitable in a falling interest rate regime.
Debt Fund managers charge a fee to manage investment portfolios called expense ratios. They were mandated by SEBI to have an upper cap of 2.00% for schemes up to a particular corpus size. Given the lower rate of returns on debt funds compared to equity funds, it is essential to invest in debt funds for extended time horizons.
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Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.