What are Debt Funds – Types, Benefits And Returns of Debt Mutual Funds
In an investor's portfolio, each asset class has a distinct role to play. Equity has the potential to create wealth; debt provides stability to the portfolio, and gold acts as a hedge against inflation, etc. In this article, we will understand the role of debt. We will focus on what are debt funds – types, benefits and returns of debt mutual funds.
What is a debt fund?
A debt fund invests most of its money in fixed income securities such as Government securities, corporate bonds, debentures (NCDs), money market instruments, etc. A debt mutual fund takes low to moderate risk and aims to generate regular income through interest and capital appreciation for its investors.
How does a debt fund work?
A debt fund collects money from its investors and invests them in various fixed income securities on their behalf. The investors are given units of the scheme in proportion to their investment. The NAV of the scheme is influenced by two factors: The interest amount received by the scheme on the fixed-income securities held and the movement of the bond prices, which is dependent on the movement of interest rates. The unitholders benefit when the unit NAV goes above their purchase price and suffer losses when the NAV goes below their purchase price.
Who should invest in debt mutual funds?
An investor with a conservative or moderate risk profile and who is happy with low to moderate returns should invest in debt mutual funds. Debt mutual funds are also ideal for investors whose main aim is to protect their capital rather than earn returns on it. Debt mutual funds are also ideal for investors looking to earn regular income on their investment in the form of dividend income.
Types of debt mutual funds
SEBI has classified debt mutual funds into 16 sub-categories depending on the types of fixed income securities they invest in and the Macaulay duration. Macaulay duration measures how long it will take for an investor to get back the amount they invested in a fixed income security (example, bond) with the cash flows earned from it. The bond cash flows include the regular interest repayments and the principal repayment on maturity.
Table: Types of debt mutual funds
|Type of debt mutual fund scheme||Scheme characteristics|
|Overnight fund||An open ended scheme that invests in overnight securities that have a maturity of 1 day.|
|Liquid fund||An open ended scheme that invests in debt and money market securities with a residual maturity of up to 91 days.|
|Money market fund||An open ended scheme that invests in money market instruments having a maturity of up to 1 year.|
|Duration funds||Open ended scheme that invests in debt and money market instruments based on Macaulay duration of the portfolio. These include: Ultra short duration fund (Macaulay duration of the portfolio 3 – 6 months), Low duration fund (Macaulay duration of the portfolio 6 – 12 months), Short duration fund (Macaulay duration of the portfolio 1 – 3 years), Medium duration fund (Macaulay duration of the portfolio 3 – 4 years), Medium to long duration fund (Macaulay duration of the portfolio 4 – 7 years), Long duration fund (Macaulay duration of the portfolio greater than 7 years), Dynamic bond fund (investment across duration)|
|Corporate bond fund||An open ended debt scheme that predominantly invests a minimum of 80% of its total assets in the highest-rated corporate bonds.|
|Credit risk fund||An open ended debt scheme that predominantly invests a minimum of 65% of its total assets in below highest-rated corporate bonds.|
|Banking and PSU fund||An open ended debt scheme that predominantly invests a minimum of 80% of its total assets in debt instruments of banks, PSUs, and public financial institutions.|
|Gilt fund||An open ended scheme that invests a minimum of 80% of its total assets in Government securities across maturity. A variant of this fund is a gilt fund with 10 years constant duration, which invests a minimum of 80% of its total assets in Government securities such that the Macaulay duration of the portfolio equals 10 years.|
|Floater fund||An open ended scheme that predominantly invests a minimum of 65% of its total assets in floating rate instruments|
How to invest in debt mutual funds according to your investment plan?
An investor can choose to invest in different types of debt funds based on their investment objective.
- Capital protection: If an investor’s main aim is to protect capital rather than earning returns on it, then they should invest in an overnight fund, liquid fund, or money market fund.
- Emergency fund: If an investor aims to build and maintain an emergency fund, a liquid fund is ideal. Some liquid funds provide an insta redemption option that transfers the redemption amount, up to a specified limit, instantly in the investor's bank account.
- Duration funds: Depending on an investor’s aim, they can choose from ultra short, low, short, medium, medium to long, or long duration funds.
- Credit risk appetite: If an investor doesn’t have any credit risk appetite, they should choose a gilt fund for investment. If an investor has a very low credit risk appetite, they can choose a corporate bond fund. If an investor can take some credit risk, they can choose a credit risk fund.
- Floater funds: In a high-interest rate scenario, where interest rates have peaked and are expected to go down in the near future, the investor can opt for a floater fund to benefit from the rally in bond prices due to a fall in interest rates.
Debt mutual funds provide stability to your investment portfolio
When equity markets are going down or volatile, debt mutual funds provide much-needed stability to your overall investment portfolio. When equity markets move down rapidly, the debt portion of your portfolio acts like a shock absorber and cushions the downside to your overall investment portfolio.
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