ALL ABOUT DEBT MUTUAL FUNDS

Namrata Singh, CFP & Chaitali Shah, MA (Economics)

Debt funds are mutual funds that invest in a variety of debt securities such as treasury bills, government securities (gilts), certificates of deposits (CDs), commercial papers (CPs), bonds, and money market securities, among others. Unlike investing directly in bonds or debt securities, debt mutual funds provide diversification and professional management, especially in underdeveloped debt markets like India.

Categories of Debt Mutual Funds:

The Securities and Exchange Board of India (SEBI) has categorized debt mutual funds into 16 categories:

1. Overnight Fund: Invests in securities with a maturity of 1 day.

2. Liquid Funds: Invest in debt and money markets with a maximum maturity of up to 91 days.

3. Ultra-short Duration Fund: Invests in debt and money market instruments with a duration of 3 to 6 months.

4. Low Duration Fund: Invests with a duration of 6 to 12 months.

5. Money Market Fund: Invests in money market instruments with a maturity of up to 1 year.

6. Short Duration Fund: Invests in debt and money market instruments with a duration of 1-3 years.

7. Medium Duration Fund: Invests in debt and money market instruments with a duration of 3-4 years.

8. Medium to Long Duration Fund: Invests in debt and money market instruments with a duration of 4-7 years.

9. Long Duration Fund: Invests in debt and money market instruments with a duration of over 7 years.

10. Dynamic Bond: Invests across different maturities based on interest rate views.

11. Corporate Bond Fund: Invests at least 80% of total assets in high-rated corporate bonds.

12. Credit Risk Fund: Invests at least 65% of total assets in lower-rated corporate bonds.

13. Gilt Fund: Invests at least 80% of total assets in government securities across maturities.

14. Gilt Fund with 10-year Constant Duration: Invests at least 80% of total assets in government securities with a duration of 10 years.

15. Floater Fund: Invests at least 65% of total assets in floating rate instruments.

16. Banking and PSU Funds: Invests at least 80% of total assets in debt instruments of banks, public sector undertakings, and public financial institutions.

Risks of Investing in Debt Mutual Funds:

1. Interest Rate Risk: Interest rates and the price of debt instruments are inversely related. Debt funds with shorter - duration instruments are less prone to interest rate risk than those with longer duration instruments.

2. Credit Risk: The creditworthiness of the investments varies and is determined by credit ratings (e.g., AAA, AA+). Higher rated instruments have higher creditworthiness than lower rated ones.

3. Inflation Risk: Fixed rate investments are impacted by inflation, which can erode returns. Higher inflation can decrease bond prices, affecting debt fund returns.

Advantages of Investing in Debt Funds

Investing in debt funds comes with several notable advantages, making them a valuable component of an investment portfolio:

1. Low Cost Structure:

○      Cost-Effective: Debt funds generally have lower expense ratios compared to equity funds, making them a cost-effective investment option.

2. Relatively Stable Returns:

○      Consistency: Debt funds tend to provide more stable and predictable returns compared to equity funds, making them suitable for conservative investors.

○     Income Generation: They are ideal for generating regular income, especially for those looking for predictable and steady returns. This can be easily achieved through SWP (Systematic Withdrawal Plans)

3. High Liquidity:

○   Easy Redemption: Debt funds offer high liquidity, allowing investors to redeem their investments quickly,  within one business day.

○     No Lock-in Period: Unlike fixed deposits, most debt funds do not have a lock-in period, providing flexibility for investors to access their funds when needed.

4. Reasonable Safety:

○   Lower Risk: Debt funds are generally less volatile and less risky compared to equity funds, as they invest in fixed-income securities like government bonds, corporate bonds, and money market instruments.

○     Risk Management: Professional fund managers actively manage the portfolio to mitigate risks and ensure reasonable safety of capital.

Debt funds are particularly suited for investors who seek regular income and are risk-averse. They provide a stable investment option with lower volatility compared to equity funds. For those who have traditionally invested in fixed-income products like bank deposits, debt mutual funds offer a better alternative by providing steady returns with low volatility. Debt funds, especially ultra-short duration funds and low-duration funds, are ideal for creating emergency funds due to their high liquidity and no exit loads.

When selecting a debt fund, it is essential to assess potential returns and risks. A good starting point is to look at each fund's Yield to Maturity (YTM) minus expenses. Potential risks such as credit risk and interest rate risk should be quantified and weighed on a case-by-case basis. The final decision should balance potential returns with potential risks. We encourage readers to assess their risk appetite thoroughly before investing in Mutual Funds.

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Namrata Singh is a Certified Financial Planner with more than 14 years of experience in banking and wealth management. (namrata@asinvestment.in)

Chaitali Shah, MCom & MA (Economics) is a Financial Coach and was a Financial Economics Faculty at Wilson College, Mumbai (info@wealthron.com)

(Please note all views are personal)

This article was first published on the Desh Gujarat website.