What are debt funds? Key benefits and market risks of investment you need to know

Debt funds are a type of mutual fund that generates returns by investing money in government bonds, debt securities, and money market instruments. The returns are usually not affected by fluctuations in the market, which makes debt funds a low-risk investment option. Since debt funds are least prone to market fluctuations, their returns may not be as high as those of small-, mid-, or large-cap funds, but they give nearly steady returns. Investors who are averse to market risks generally opt for debt funds.

Pratik Shroff, Fund Manager – Fixed Income at LIC Mutual Fund, highlights the versatile role of debt funds in managing both short-term and long-term liabilities. He emphasizes the importance of investing in the right maturity bucket schemes to effectively address impending financial obligations.

"Debt funds can help in managing both short term and long-term liabilities as when they come due if investments are made in the right maturity bucket schemes. Another major risk is the credit risk" Shroff said.

"One can also take direct exposure to debt, however the exit may become difficult and costly in such a case and also one may not be able to adjust portfolio based on macro-economic cycles" he added.

Types of Debt Funds:

There are 16 types of debt funds categorised by the market regulator, Securities and Exchange Board of India (SEBI), on the basis of their risks. Here are the 16 types of debt funds:

1. Overnight Fund: This debt fund has a maturity period of just one day.
2. Liquid Fund: These funds invest in short-term money market instruments with a maturity of up to 91 days.
3. Ultra Short Duration Fund: These funds invest in debt and money market instruments with an average holding period of six to 12 months.
4. Low-Duration Fund: These funds invest in debt securities with a maturity of up to 1 year.
5. Money Market Fund: This involves investing in money market instruments with a maturity of up to one year.
6. Short-Duration Fund: These funds invest in debt and money market instruments with a portfolio duration between 1 and 3 years.
7. Medium-Duration Fund: These funds invest in debt and money market instruments with a portfolio duration between 3 and 4 years.
8. Medium to Long-duration Fund: They invest in debt and money market instruments with a portfolio duration between 4 and 7 years.
9. Long-distance Fund: This category invests in debt and money market instruments with a portfolio duration greater than 7 years.
10. Dynamic Bond: This type of debt fund helps spread out your investments over a variety of time horizons.
11. Corporate Bond Fund: Ensure a minimum of 80 per cent investment in corporate bonds with a rating of AA+ and above.
12. Credit Risk Fund: Ensure a minimum of 65 per cent investment in corporate bonds, but only in those rated AA and below.
13. Banking and PSU Fund: Invest at least 80 percent of your money in debt instruments such as municipal bonds, PSUs (public sector undertakings), banks, and PFIs (public financial institutions).
14. Gilt Fund: It needs at least 80 per cent of investments in government securities (G-secs) across various maturities.
15. Gilt Fund with a 10-year constant duration: Allocate at least 80 per cent of investments in G-secs with a portfolio duration equal to 10 years.
16. Floater Fund: Allocate at least 65 per cent of investments in floating-rate instruments, including those converted from fixed rates through swaps or derivatives.

Benefits of Debt Funds: Here are some benefits that debt funds offer

• Consistent interest income and capital appreciation.
• Diversification across a variety of debt instruments helps reduce risk.
• Liquidity allows investors to buy and sell units with ease.
• Since they are less risky than equity funds, debt funds provide a safer option for conservative investors.
• Suitable for those who want investment with short- and medium-term horizons.

How to know the risk of investing?

Though these funds are thought to offer good returns, they also come with risks. So, it's important to be aware of the risks before making an investment in debt funds.

“The allure of higher returns often comes with higher risks. If one attempts to boost the interest component by investing in lower-rated instruments, it introduces the risk of capital loss in adverse conditions, says Deepak Jain of Edelweiss Mutual Funds.

“Similarly, a long tenure of underlying securities exposes them to valuation risk, as any unfavourable movement in interest rates can lead to a downside in the price,” he added.

Deepak also explains how the bond price can impact interest rates. “The price of a bond is inversely proportional to interest rate movements. An essential risk to be vigilant about is liquidity. Lower-rated instruments may not always provide easy liquidity," he further said.

Another way to identify the risks is to analyse the schemes run by fund houses.

Financial expert Pratik Shroff said that the fund houses can run multiple schemes addressing the duration and the credit issues. "One can look at the scheme information document of any schemes and portfolios update by MF to identify this" he added.

"The best way to understand the risks is by looking at the Macaulay duration of the portfolios and the percentage allocation to assets below the AAA grade. This can give a quick idea of the strategy" Prateek said.

"As per SEBI mandate the debt schemes have to choose a Potential Risk Class (PRC) matrix based on credit and interest rate risk signifying the maximum risk that the scheme can undertake. Investors can look at the matrix and decide where to invest" he further said.

What are the risks of debt fund investment?

Debt fund investment also has some risks. Here is the list of those risks in debt funds:

• Interest risk
• Credit risk
• Liquity risk
• Spread risk
• Counterparty risk
• Prepayment risk
• Re-investment risk

Interest risk: When interest rates rise, prices of fixed-income securities fall, and vice versa. This affects the value of a scheme's portfolio.

Credit Risk: It is associated with default on interest or principal amounts by issuers of fixed income securities. Government securities are safer than corporate bonds, which carry higher credit risk.

Spread Risk: Credit spreads on corporate bonds may change, impacting the market value of debt securities in a portfolio.

Liquidity Risk: It refers to the ease of selling securities at their true value. Tight liquidity conditions may lead to higher impact costs.

Counterparty Risk: There is a risk of the counterparty failing to fulfill transactions, leading to potential losses.

Prepayment Risk: It arises when borrowers pay off loans earlier than due, affecting the yield and tenor of asset-backed securities.

Re-investment Risk: There is a risk that reinvesting interim cash flows at lower rates may result in a lower realised yield than expected.

Who should invest, or how should you choose the right one for you?

Deepak Jain also describes that if anyone wants to invest in debt funds, they have to follow this strategy:

Choosing the right funds to invest depends on the person-to-person or individual. If you are a conservative investor, you would prefer to choose a fund with high-quality credit and low maturity.

On the other side, if you are able to take a risk, then choose funds with lower credit ratings, higher maturities, or a combination of both to seek potential higher returns and liquidity challenges.

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