Different Types of Debt Funds

Debt funds in mutual funds invest in fixed-income securities like treasury bills, corporate bonds, commercial papers, government securities, and many other money market instruments. The NAV or Net Asset Value of Debt Mutual Funds is inversely related to interest rate movement. Generally, when the interest rates rise, the prices of existing fixed income securities in your debt mutual fund portfolio fall and when interest rates drop, such prices increase.

Types of Debt Funds in India

Dynamic Bond Funds
Dynamic Bond Fund is a type of debt fund where the fund manager adjusts the portfolio as per the fluctuating interest rates. Dynamic bond funds have different average maturity periods as these funds take investment decisions based on interest rates and invest in instruments of longer and as well as shorter maturities.

Short Duration Debt Funds
These type of debt funds make investments in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 1 year – 3 years.. Conservative investors prefer these funds, as they are generally not influenced much by interest rate movements.

Liquid Funds
Liquid funds is a type of debt fund consisting of underlying debt instruments with a maturity of not more than 91 days. This makes them relatively less risky. Liquid funds can be an option to park investor’s surplus fund and can act as emergency funds.

Gilt Funds
These type of Debt funds make minimum investment in Gsecs- 80% of total assets (across maturity) and considered to have low credit risk. . The government rarely defaults on the loan taken in the form of debt instruments; gilt funds are perfect for risk-averse fixed-income investors.

Fixed Maturity Plans
These types of Debt funds also make investments in fixed income securities like corporate bonds and government securities. All FMPs have a fixed period for which your money will be locked-in. However, one can invest only during the initial offer period there after can be purchased or sold through stock exchange platform.

From an investor’s point of view, debt funds in India are regarded as relatively less volatile than equity mutual funds.. However, there are different types of risks associated with debt funds.

Credit Risk

Debt funds extend money to companies, banks, and the government. The possibility of loss because of a company defaulting on payment is called credit risk. Banks and the government have a safer credit profile than companies. Certain mutual funds hoping to generate higher returns lend to companies with low credit profiles, which leads to such events. Hence, one should examine the debt fund portfolio before investing.

Liquidity Risk

Certain securities have less liquidity as compared to others or there could be economic issues wherein the liquidity of debt securities decreases. In such cases, the mutual funds cannot sell these securities and repay investors. This is known as liquidity risk.

Interest Rate Risk

This is one of the most common risks involved in debt funds. Increasing interest rates lead to falling bond prices and vice versa. In a falling interest rate environment with rising bond prices, funds with the highest duration do well. If a fund manager, buys bonds with a long duration assuming interest rates will go down, but interest rates go up such a fund will yield low or negative returns. This is an interest rate risk.

To conclude, there are different types of risks associated with debt funds.

The investor should maintain debt funds in mutual funds as a part of the portfolio after evaluating the risks involved and your investment objective.