What are the different types of debt funds?

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What are the different types of debt funds?

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If you are a salaried professional like me, you will agree that a SIP — or a Systematic Investment Plan — can be life savers. I only started my SIPs a year ago, and I’m already happy about how my portfolio looks today. It has a mix of equity funds, tax-saving funds, and debt mutual funds. 

Interestingly, I only got to know more about this last category, namely debt funds, quite recently. Did you know that there are debt fund types for every kind of investor? 

Let’s begin with the basics and take a deep dive into what debt funds are and how multifaceted this market segment is.

What is a debt mutual fund?

A debt mutual fund is an investment vehicle that pools together money from different investors. This money is then used to invest in different debt securities like government bonds, corporate bonds, money market instruments and more. Also, since most of the debt instruments in the Indian financial market offer fixed income, these funds are also known as fixed income funds. 

That said, debt oriented mutual funds do not invest only in debt instruments. They may also have a small portion of the funds allocated to equities. 

Are there different types of debt mutual funds?

Yes, of course! Depending on the type of debt instruments they invest in and the maturity period of those instruments, debt funds can be of many different kinds. Want to find out more about the different debt fund types available in the market? 

Here is a preview.

Debt fund types based on the instruments they invest in

There are several types of debt securities and fixed income instruments in the market. And different debt funds choose to invest in different debt securities. So, based on the assets in the fund’s portfolio, they can be of the following types —

Gilt funds

Gilt funds are debt oriented mutual funds that invest at least 80% of their corpus in government securities. The maturity period of these securities may vary from short term to long term. Since government instruments come with the sovereign guarantee, gilt funds carry little to no credit risk or default risk. This means that the chances of you not getting your money back are practically zero. 

However, government securities do carry interest rate risks. This is because the interest rates on the instruments may change over the investment tenure. As a result, the value of the securities you hold may decline.

Banking and PSU funds

Like the government, banks, public sector undertakings (PSUs) and public financial institutions (PFIs) also issue securities. Banking and PSU funds, as you may have guessed, invest around 80% of their capital in these securities. 

These instruments may carry a slightly higher risk than securities that are issued by the government. Nevertheless, these debt oriented mutual funds give you a nice balance of fixed returns and liquidity.

Corporate bond funds

Like the government, many companies in India also issue long-term bonds. These securities, known as corporate bonds, are assigned ratings by credit rating companies. The ratings indicate the risk of default aka the credit risk. 

Corporate bond funds are debt funds that invest around 80% of their corpus in corporate bonds that are highly rated. This reduces the credit risk on the investments. 

Credit risk funds

Credit risk funds also invest around 65% of their corpus in corporate bonds. However, in these debt oriented mutual funds, the bonds in the portfolio carry a lower credit rating. To compensate for this increase in credit risk, these bonds come with the potential to offer higher returns. 

Floater funds

Floater funds are debt funds that invest around 65% of their capital in floating rate bonds. The rate of interest on these bonds are periodically reset based on the market interest rates. This significantly reduces the interest rate risk carried by these securities.

Debt fund types based on the maturity period 

The securities that debt funds invest in come with varying maturity periods. Based on this tenure, debt funds can further be classified into different types, as I’ve explained below —

  1. Overnight funds

Overnight funds invest in debt instruments that have a maturity of just 1 day. They have practically zero credit risk and interest rate risk.

  1. Liquid funds

Liquid funds invest in securities that have maturity periods of up to 91 days. They are ideal for you if you want to park your funds in a secure investment vehicle for around 3 months, and also earn some little bit of income in the process.

  1. Ultra short duration funds

Ultra short duration funds have maturity periods ranging from 3 to 6 months. They offer slightly higher returns than liquid funds. 

  1. Low duration funds

These funds invest in securities with maturity periods ranging from 6 months to 1 year. They may occasionally include bonds with a low credit rating. So, make sure you check the portfolio before investing in these funds. 

  1. Short duration funds

If you are a conservative investor with an investment horizon of 1 to 3 years, you can choose to invest in short duration debt funds. The returns in these funds may be higher than liquid and ultra-short duration funds. However, they may also be a tad bit more volatile.

  1. Medium duration funds

Medium duration funds have a portfolio with securities that mature within 3 to 4 years. 

  1. Medium to long duration funds

Medium to long duration funds may have maturity periods ranging from 4 years to 7 years.

  1. Long duration funds

As the name indicates, these debt oriented mutual funds have securities with maturity periods of 7 or more years. 

Summing up

See how many different types of debt funds there are? Even within a seemingly narrow asset category, the variation can be surprising. You can choose debt funds based on your risk profile and your investment horizon. For instance, if you can afford to take on more risks, you can choose credit risk funds. They may be riskier than corporate bonds funds, but are still safer than direct equity investments.

Similarly, you can choose the funds with securities whose maturity periods match your investment horizon. If you want to invest for a goal that you need to achieve 5 years down the line, a medium to long duration fund may be ideal. In this manner, you can find debt fund types for every goal on your list.

Frequently Asked Questions (FAQs)

1. Which type of debt mutual fund is best?

Depending on the type of debt instruments they invest in and the duration of the investment, there are different kinds of debt mutual funds. To determine what is the best debt oriented mutual fund for you, you need to assess your financial goals, your risk appetite and your investment horizon.

2. Which type of debt fund should I invest in?

Given the different debt fund types, it may be challenging to decide which kind of fund to invest in. The right option for you depends on your investment purpose, risk profile and investment horizon. 

For instance, if you are an extremely conservative investor with a long-term goal, you can choose debt oriented mutual funds that invest in government bonds. Alternatively, if you are willing to take on some level of risk in exchange for marginally higher returns, debt funds that invest in corporate bonds may be ideal.

3. What is a debt category mutual fund?

A debt oriented mutual fund is an investment vehicle that invests primarily in debt instruments like government bonds, corporate bonds or other fixed income securities. 

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