Debt Mutual Funds
Debt oriented funds are those which primarily invest in fixed income securities like Treasury Bills, Government Securities, Money Market Instruments, Corporate Bonds, etc. The returns arise from interest accrual and capital appreciation of these securities.The fund can hold short or long term securities, or a basket of securities with different tenures. They have lower returns than equity funds, but generate more stable returns.
Debt funds are often considered risk-free, but that is far from the truth. Since equity funds are market-linked, they are more volatile than debt funds. However, returns on debt funds are also volatile, based on the investment strategy of the investor.
Holding debt fund units is different from holding a debt instrument till maturity. In the latter case, the investor is not affected by the change in interest rates, and the price of the instrument as he does not look for selling it in the secondary market. But in case of debt fund, where different instruments of varying maturities are held, active management requires buying and selling in the secondary market at the market price of the instruments. This determines the price of the NAV of the fund. Debt funds are less volatile than equity funds, but are volatile nonetheless. Some of the risks associated with debt funds are as follows:
Interest rate risk:
This refers to a change in the price of a debt security due to a change in interest rates. The price of the security is directly impacted by interest rate risk. This affect the value of the fund. For example, in case of a rising interest rate scenario, funds
holding shorter maturity instruments will do well; whereas in case of a falling interest rate scenario funds holding a longer maturity instruments will perform well. Interest rate risk increases with longer duration funds, as short term funds can liquidate their instruments and invest in fresh instruments when the interest rates increase.
Credit risk:
Credit risk refers to the risk associated with the repayment ability of the issuer of the instrument. Government bonds therefore do not carry any credit risk. It takes into account whether the issuer is able to make interest payments on time as well as the maturity value when due. Defaulting by the issuer brings down the credit rating of his instruments, causing its price to fall. This will impact the NAV of the fund holding the instrument.
Liquidity risk:
Some funds may hold securities that are not easily sold in the secondary market. If the fund holds such securities, the lack of liquidity may affect the fund value.Generally, government securities and money market instruments are highly liquid. Corporate bonds are less liquid, and the ones with a lower credit rating are even less liquid. Therefore, funds holding such illiquid bonds face liquidity risk. In case of downturn, these bonds may not be transferable easily, and may have to be sold at a discount, significantly affecting the value of the fund holding it.
Types of Debt Funds
Liquid Funds
They invest in money market instruments that are highly liquid. Liquid fund is a good option for corporate and institutional investors as well as individuals to park surplus funds for a period of as short as a day.
UltraShort-Term Funds
Also known as Liquid Plus Funds, these invest in securities that have a maturity period of less than one year. They are apt for investors willing to take slightly higher risk for a short term surplus available for 1-9 months.
Floating Rate Funds
These funds invest in floating-rate securities and are suitable in an increasing interest rates scenario.
Short and Medium–term Income Funds
These funds invest in instruments with maturities of up to 3 years. They are suitable to invest in when short term interest rates are higher and benefit from capital appreciation when the rates fall.
Income Funds
Income funds are debt funds that aimed at providing stable returns to be paid out in any interest rate scenario, through active portfolio management. Although they are a type of debt funds, income funds can give negative returns in some cases. For example, if interest rates fall drastically, the underlying bond prices may also reduce. Or if the fund manager chooses to invest lower-rated instruments to increase returns, the fund may end up with default on interest payments, leading to negative returns.
Gilt Funds
Gilt Funds are mutual funds that invest only in government securities. The underlying securities do not carry any credit risk. However, gilt funds, due to their investment strategy, are among the higher risk debt products. They hold securities of varying maturities and it is essential to track your returns in gilt funds to exit at the right time. In recent years, gilt funds have outperformed dynamic bond funds by giving 8-11% returns due to declining yields in a dovish interest rate scenario.
Dynamic Bond Funds
Dynamic Bond Funds tend to use a combination strategy of holding-to-maturity as well as trading of bonds for capital appreciation. It has exposure to both short-term and long-term securities, and therefore it is difficult to classify them according to time duration. They also perform well in a falling interest rate scenario by providing capital returns. They have given returns of 7-10% over a 3-5-year term in the recent past.
Fixed Maturity Plans
These are closed-ended debt funds in which the securities are held to maturity and the time frame of the fund is roughly matched with the maturities of the securities held.
Hybrid Funds
These funds consist of a combination of debt and equity instruments in varying proportions. They carry a higher risk and reward compared to other debt funds due to the equity component.