What Are Debt Funds, Types, Benefits? (2023)

A debt fund is a mutual fund scheme that invests in debt instruments like Corporate and Government Bonds, corporate debt securities, and money market instruments,etc. There are different types of debt funds to suit investors with varying risk-return profiles, investment horizons, and financial goals. Debt funds invest in all kinds of debt, such as treasury-bills, government securities, commercial paper, certificates of deposits, money market instruments, securitized debt, and corporate bonds. It is also known as Fixed Income Funds or Bond Funds.
The key difference between a debt fund and an equity fund is that they invest in different asset classes. Equity funds invest 65% or more of their assets into equity and equity-linked products, while debt funds hold mainly bonds and cash assets. Remember that the value of an investment depends on the prices of the securities that make up the investment. Since bond prices tend to be less volatile than stock prices, debt fund values are more stable than the value of equity funds. In other words, debt funds are considered to be less risky, especially when held for short periods of time.

Here are the different types of debt funds:

• 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.

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• Ultra-short Duration Funds:

  Ultra-short Duration Funds are suitable for investors who have an investment horizon of at least 3 months. These funds earn slightly higher yields than liquid funds and are considered to be a low risk investment. Some ultra-short duration funds may invest in lower-rated bonds to push up their yields.

• Low Duration Funds:

  Low Duration 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.

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• Money Market Funds:

  Money Market Funds invest in debt instruments with maturity upto 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 fund 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):

  Fixed Maturity Plans (FMPs) 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 safety of principal.

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• Credit Risk Funds:

  Credit Risk 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:

  Banking and PSU Funds invest at least 80% of total asset 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.

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• 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:

  Dynamic 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.

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 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 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.

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• 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.
• 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 investment.
• 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.