Understanding Different Types of Debt Mutual Funds
Last Updated : July 11, 2020, 5:57 p.m.
Debt funds have been a popular choice of investment for many individuals and companies in India. These funds contribute the maximum Assets Under Management (AUM) of the total mutual fund AUM in our country. Though investments in debt funds have increased manifold, there is still ambiguity among investors on which debt fund is right for them.
In this post, we decode all types of debt funds to lend clarity to this subject. Before moving on to the different types of debt funds, let us first understand what debt funds are.
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What are Debt Funds?
Debt funds are a type of mutual fund that invests in debt securities such as corporate bonds, money market instruments, commercial paper, certificate of deposit, treasury bills and government securities. These funds do not invest in equity shares.
Different types of debt funds have different investment objectives and investing mandates. Some funds invest in varying maturities or duration of debt securities. So, there could be a debt fund investing in securities maturing in a day, month, year, three years and more.
There are some debt funds that can be considered as a good alternative to keeping money in a savings bank account or fixed deposit but not all debt funds are a direct replacement for these banking products. Also, debt funds carry different kinds of risks, which need to be fully understood before investing.
There are 16 different types or categories of debt funds, let us explain each.
Different Types of Debt Funds
Liquid Fund
Liquid funds are a type of debt fund that invests in treasury bills, commercial papers, bank fixed deposits. The maturities of all these in a liquid fund is up to 90 days. When you invest your money in a liquid fund, the same is lent by the mutual fund to institutions such as banks and corporates. To know about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/5-best-performing-liquid-funds-to-invest-in/
Gilt Fund
Gilt Funds or government securities funds are those funds that invest in bonds issued by the government of India. The government is the largest borrower in the Indian debt markets, it borrows money by issuing securities of various time periods.
This is done to fund government expenditure on various things such as infrastructure, social spending, health, defence, education, etc. To know about these funds, you can read another post of ours- Are Gilt Funds a GOOD Option to Invest in
Banking and PSU Debt Funds
Banking and PSU funds are open-ended debt funds that invest at least 80% in debt securities of government banks, PSUs (public sector units) and government-owned/run financial institutions.
All government-owned banks, PSU enterprises issue bonds and other debt securities in the debt market to raise funds. These securities are bought by mutual funds under this fund. The objective of these funds is to deliver steady returns with a good quality portfolio. To know about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/banking-and-psu-debt-funds-benefits-should-you-invest-in-them/
Dynamic Bond Fund
These funds are dynamically managed which means they have the flexibility to buy and sell debt securities of different maturities basis the view on interest rates. Factors such as inflation, growth and fiscal deficit determine the interest rates in an economy. When the economic growth is slow, interest rates are reduced to spur demand and vice versa. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/dynamic-bond-funds-definition-advantages-should-you-invest-in-them/
Overnight Fund
Overnight funds are open-ended debt mutual funds that invest in securities with overnight or one-day maturities. These securities are treasury bills, certificate of deposits, commercial papers, floating rate debt instruments.
This implies that the fund manager buys these debt securities every day for a day and sells it the next day. He/she again buys these securities the next day, again for a day and this is how the portfolio is managed. Overnight funds do not invest in securities with a maturity profile of more than a day. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/overnight-debt-funds-definition-advantages-should-you-invest-in-them/
Short Duration Fund
Short duration or short-term funds, as they are called, are a category of debt funds that invest in money market instruments such as government securities and corporate bonds. As the name suggests, the duration of these securities is short, it is in the range of 1 to 3 years.
The returns from short duration funds are determined by the interest rates in the economy. All the bonds or securities in the short duration fund are marked to market (MTM) and their price movement increases or decreases basis the movement in interest rates. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/three-best-short-duration-funds-to-invest-in/
Credit Risk Fund
A credit risk fund is a debt fund that invests in corporate bonds and commercial papers. The money you invest in a credit risk fund goes to the mutual fund company which further lends it to corporates.
What makes credit risk funds distinct is that minimum 65% of the portfolio should be invested in lower rated corporate debt. The rating of the bonds in a credit risk fund is below AA, the highest rating for a corporate bond is AAA. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/what-are-credit-risk-mutual-funds-and-should-you-invest-in-them/
Floating Rate Debt Fund
Floating rate debt funds are open-ended debt funds that invest in debt securities having a floating rate (rate here means the interest rate on that security).
These debt securities do not have a fixed rate of interest. This feature makes floating rate funds different from all other debt funds that buy securities having a fixed interest rate. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/floating-rate-debt-funds-definition-benefits-and-should-you-invest-in-them/
Fixed Maturity Plans
Fixed Maturity Plans (FMPs) are close-ended debt funds that invest in debt securities for a fixed tenure. This tenure could be anywhere between 1 month to 5 years and even more. FMPs are not open-ended i.e. you cannot buy and sell at your will; they are different from all other debt funds in this aspect.
FMPs are launched by mutual fund companies from time to time as an NFO (new fund offer), somewhat similar to an IPO in equity and you can invest only during the NFO period. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/fixed-maturity-plans-definition-features-and-should-you-invest-in-them/
Gilt Funds with a 10-Year Constant Duration
These funds are open-ended debt funds that invest in government securities that have a constant or fixed duration of 10 years. For simplicity, you can assume duration to be the period in which the debt security will fully mature and return all coupons or interest payments. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/gilt-funds-with-10-year-constant-duration-features-should-you-invest-in-them/
Long Term Duration Debt Fund
Long term duration funds are open-ended debt funds that invest in debt securities with a duration between four to eight years. For simplicity, you can assume duration to be the period in which the debt security will fully mature and return all coupons or interest payments. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/long-term-duration-debt-funds-definition-factors-should-you-invest-in-them/
Low Duration Debt Fund
Low duration funds are open-ended debt funds that invest in debt securities with a duration between six to twelve months. For simplicity, you can assume duration to be the period in which the debt security will fully mature and return all coupons or interest payments. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/low-duration-debt-funds-definition-benefits-and-should-you-invest-in-them/
Medium Term Duration Debt Fund
Medium duration funds are open-ended debt funds that invest in debt securities with a duration between three to four years. For simplicity, you can assume duration to be the period in which the debt security will fully mature and return all coupons or interest payments. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/medium-duration-debt-funds-definition-factors-should-you-invest-in-them/
Money Market Debt Fund
Money market funds are open-ended debt funds that invest in different kinds of debt securities such as treasury bills, commercial papers and certificates of deposit.
These funds buy securities with a short-term maturity ranging between three months to a year. In terms of fitment, these can be slotted between liquid funds and short term income funds in terms of risk and return profile. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/money-market-debt-funds-definition-and-should-you-invest-in-them/
Corporate Bond Funds
Corporate bond funds are a category of debt funds that invest in bonds issued by corporates or companies. Corporates need capital to run their business and fuel their growth plans and resort to debt markets to raise such capital.
These funds have a high credit quality since 80% of the portfolio must be invested in companies with a rating of AA+ and they can invest up to 20% in securities with a rating below AA+. This makes these funds less risky when it comes to credit defaults, especially as compared to credit risk funds. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/five-best-performing-corporate-bond-funds/
Ultra Short Term Fund
Ultra short term funds are a type of debt funds that invest in debt securities (corporate bonds, government securities and money market instruments) with an average maturity of 3-6 months. They are like liquid funds with the exception that liquid funds cannot invest in securities with maturities beyond 91 days. Since these funds invest in securities with higher maturities, the risk and return are relatively higher than liquid funds. To know more about these funds, you can read another post of ours- https://www.wishfin.com/mutual-fund/five-best-ultra-short-term-funds-to-invest-in/
Key Takeaways
- All debt funds are not the same, return and risk is different.
- You should choose the right debt fund based on your investment objective and asset allocation.
- Not all debt funds are an alternative to savings accounts or fixed deposits.
- Debt funds are not completely risk-free; however, the risk can be minimized if you pick the right fund.
- Your time horizon of investment should be a key parameter while choosing a debt fund.
- Debt funds are a good option for your fixed income portfolio.