What are Debt Mutual Funds?

Debt fund is a mutual fund that invests in fixed-income instruments like corporate bonds and government bonds, corporate debt securities, money market instruments, etc. These funds are also known as income funds or bond funds. Debt funds are considered to be less risky, especially when held for short periods of time.

1. Types of Debt Funds

There are different types of debt funds to suit investors with varying risk-return profiles, investment horizons, and financial goals which are as followings:

• Overnight Funds: Overnight Funds invest in securities having a maturity of 1 day, typically money market instruments. These funds aim to provide liquidity and convenience, rather than high returns. They are suitable for investors (mainly corporate treasuries) looking to park funds for a very short period.
• Liquid Funds: Liquid funds invest in debt securities with less than 91 days to maturity. They are suitable for investors who want to park temporary cash surpluses for a few days, as they provide steady returns with minimum NAV volatility.
• Ultra-short Duration Funds: These funds are suitable for investors with an investment horizon of at least 3 months. These funds earn slightly higher yields than liquid funds and are considered low-risk investments. Some ultra-short-duration funds may invest in lower-rated bonds to push up their yields.
• Low-Duration Funds: These funds are moderately risky and provide reasonable returns. They are useful for those looking to invest for around 6 months to one year. Their portfolio may include bonds with a weaker credit rating to kick up yields.
• Money Market Funds: Money market funds invest in debt instruments with a maturity of up to one year. They aim to generate returns from interest income, while their slightly longer duration offers some scope for capital gains.
• Short-Duration Funds: Short-duration funds invest in a judicious combination of short and long-term debt, as well as across credit ratings. These funds are recommended for investment horizons of 1-3 years. They usually earn higher returns than liquid and ultra-short duration funds but also show more NAV fluctuations.
• Medium, Medium to Long, and Long Duration Funds: Under normal situations, the portfolio duration of a medium-duration fund has to be between 3-4 years, medium-to-long duration funds between 4-7 years, and long-duration funds greater than 7 years. These funds invest in short and long-term debt securities of the Government, public sector, and private sector companies. They tend to do well when interest rates are falling but underperform when rates are rising. Thus, they carry fairly high-interest rate risk.
• Fixed Maturity Plans (FMPs): These are closed-end funds that invest in debt securities with maturities that match the term of the scheme. FMPs typically invest in low-risk, highly-rated debt and hold passively until maturity, when the securities are redeemed and paid out to investors. The main advantage is that the FMP structure eliminates interest rate risk and enables investors to lock in interest rates. The main drawback is that though FMPs are listed, liquidity tends to be low.
• Corporate Bond Funds: Corporate bond funds must invest at least 80% of the portfolio in AA+ or higher-rated corporate bonds. Such funds are appropriate for risk-averse investors looking for regular income and the safety of the principal.
• Credit Risk Funds: These funds invest a minimum of 65% of total assets in corporate bonds rated AA or below. That is why they usually generate higher yields as compared to the more conservative corporate bond funds. Investors who are willing to take on higher default risk may consider investing in credit-risk funds.
• Banking and PSU Funds: These funds invest at least 80% of total assets in debt instruments issued by banks, PSUs, and public financial institutions. This is a moderate-risk product that seeks to balance yield, safety, and liquidity.
• Gilt Funds: Gilt funds invest in government securities of varying maturities. They can be short or long-duration funds, depending on the maturity of their portfolio. Gilt funds have zero default risk because they invest in safe g-secs.
• Gilt Funds with 10-year constant duration: Gilt Funds with 10-year constant duration invest at least 80% of total assets in g-secs and maintain a constant portfolio duration of 10 years.
• Floater Funds: Floater funds invest at least 65% of their assets in floating-rate bonds. These funds carry less MTM risk because the coupons on their floating-rate debt holdings are reset periodically based on market rates.
• Dynamic Funds: These funds have no restrictions on security type or maturity profiles for investment. The best-performing dynamic funds manage their portfolios dynamically and flexibly according to market situations.

2. Why invest in debt funds?

Debt funds offer many benefits, especially to retail investors, or to investors who have traditionally kept their money in bank deposits.

• Access to Professional Expertise and Market Returns: Investing in a debt fund offers the opportunity to earn interest as well as capital gains from debt. It allows retail investors to access money markets or wholesale debt markets- segments in which they cannot directly invest.
• Lowers Portfolio Risk: Since debt funds are less risky than equity funds, a strategic allocation to the best-performing debt funds reduces risk and brings stability to an investment portfolio. Tactical investments in debt funds are useful to take advantage of temporary yield opportunities.
• Range of investment options: Debt funds are available along the entire spectrum of maturity and credit risk. Shorter-duration funds generate regular and stable income. Longer duration funds earn from interest income as well as capital gains and suit investors who can take on higher NAV volatility. Overnight funds, liquid funds, corporate bond funds, and low-duration funds tend to invest in the safest debt products. Ultra-short and short-duration funds may be structured to take on credit risk to provide higher returns.
• Liquidity: Debt funds are very liquid, and can be redeemed easily, usually within one or two working days of placing the redemption request. Unlike bank fixed deposits or recurring deposits, there is no lock-in period. While a few funds may impose a small exit load for early withdrawal, in general, there are no penalties when a mutual fund investment is withdrawn.
• Low-Cost Investment: According to the SEBI norms, the total expense ratio of a debt fund cannot exceed 2% of Assets under Management. Among debt funds, overnight and liquid funds have very low expense ratios, while dynamic and long-term funds charge higher expense ratios.

3. Top Performing Debt Mutual Funds

4. How Debt Dunds Different From Equity Mutual Funds?

Equity mutual funds invest in companies by buying their stocks. So when you invest in them, you become part-owner of the company the fund puts money in.

The returns equity funds are generated through a combination of selling a stock at a higher price and the dividend received from the company. So the returns you get are dependent on the performance of the company. If the company does well, the price of stock increase as more people want to own it, plus the company might share the profits with shareholders via dividends. If it doesn’t do well, you might lose money. So the risk is higher, but so are the rewards.

On the other hand, debt funds lend to corporates. When you invest in them, you become a lender to these companies, not owners. The returns are generated by the interest received and the price appreciation of the Bond. For this reason, the performance of the company doesn’t have much impact on the returns – as long as it doesn’t default, you will get returns. However, the returns will not be as high as Equity Funds.

That doesn’t mean there are no risks in Debt Funds.

5. What are the risks of investing in Debt Mutual Funds?

Yes. There are risks involved in investing. Be it equity or debt. However, the amount of risk is way lesser in debt funds when compared to equities. Within debt funds, there are categories with almost negligible. 

There are two risks associated with Debt Mutual Funds – Credit Risk and Interest Rate Risk.

Let’s see what they are and how you can minimize them.

Interest Rate Risk

As mentioned above, the price of bonds rises and falls based on the interest rates in the economy, and that is the first risk associated with debt funds.

In the above-mentioned example, the price of the Bond increased because its interest rates went down. But what if the interest rates in the market go up? New bonds will give a higher interest rate, and hence the existing Bond’s value will go down (due to low demand). Subsequently, the NAV of the fund will fall.

Since it is not possible to predict how interest rates will move, the best way to mitigate this risk would be to invest in those fund categories that lend for short-duration to medium-duration periods. That’s because interest rates don’t change drastically in a short period.

Credit Risk

The other risk is that the borrower defaults and doesn’t pay interest and/or principal amount back.

This risk played out sometime back when DHFL and IL&FS defaulted. The bonds issued became zero value, and mutual fund investors had to take a hit because of this.

The best way to avoid this risk is to invest in a debt fund that lends to highly rated corporates. Ratings assigned by credit agencies like CRISIL are a good indicator of the financial health of these companies. AAA rating indicates the lowest credit risk.

One thing worth noting is that since high-rated borrowers are less risky, they also give you lower interest rates.

6. Investment Strategy of Debt Mutual Funds

Debt Mutual Funds primarily follow two strategies to generate returns – an Accrual Strategy or a Duration Strategy. While these two strategies are quite different, few funds use only one of these strategies to generate returns. Most Debt Funds actually use a combination of these two strategies to maximize their returns.

Accrual Strategy

The Accrual Strategy of Debt Funds aims to generate consistent returns for the investor by investing in Bonds and holding them till maturity. This strategy focuses on receiving interest income from the Bonds it invests in. As a result of holding investments till maturity, the interest rate risk of these Debt Funds is quite low. This strategy is primarily used by Liquid Funds, Ultra Short Duration Funds, Low Duration Funds, and Money Market Funds. Debt Funds that follow this strategy are an ideal investment if you are seeking consistent returns with limited risk.

Duration Strategy

Debt Funds using the Duration Strategy focus on generating returns by actively buying and selling Bonds based on interest rate movement predictions. Debt investments following this strategy usually make a profit when Interest Rates fall leading to an increase in the price of Bonds as mentioned in the earlier example. The Duration Strategy is usually followed by Long Duration Funds, Dynamic Bond Funds, and Gilt Funds.

Mutual Funds that use a Duration Strategy have significant interest rate risk i.e. the fund might incur a loss if the interest rates start moving upwards instead of downwards. In order to mitigate this risk, these Debt Funds often invest in shorter-duration Bonds when an Interest Rate increase is predicted. On the other hand, longer-duration Bonds are preferred by these schemes when a decrease in Interest Rates is predicted.

7. Summary

• Debt funds are mutual funds that invest in debt securities.
• There are many types of debt funds that invest across the maturity and credit risk spectrum.
• Debt funds earn accrual income from coupons and capital gains/losses as NAV is marked up or down due to changing market yields.
• How much a fund earns from interest and how much from capital gains depends on the type of bonds in its portfolio.
• Funds with lower average maturity or duration earn mainly from interest payments. Funds with a longer average maturity earn from interest coupons as well as capital gains.
• These funds can invest in lower-rated debt to push up yields, but that also increases credit risk. They can increase average maturity by increasing holdings of long-term debt, but that increases the interest rate risk.
• Debt funds offer a low-cost and convenient method of taking debt exposure. They offer several advantages over traditional bank deposits as well as direct bond investments.
• Debt funds bring stability to an investment portfolio. They are useful for investors seeking regular and steady income, to facilitate goal-based financial planning, and to earn alphas from interest rate changes.