Understanding the different types of debt funds available in India

Debt funds invest in fixed-income instruments like government and corporate bonds, CDs, T-bills, commercial papers, and other money market instruments to offer stable returns against a low capital risk. Most beginners consider debt funds as a homogeneous category of funds that invest in the same fixed-income assets. This is far from true. There are various types of debt funds available in the market with varying investment durations and risk levels. As an investor, you should understand them thoroughly before picking a fund for your portfolio. This article outlines the different types of debt funds you can find in India and highlights how you can choose right debt fund for your investment portfolio.

Learning about the different types of debt funds available in the Indian market is essential for any potential investor. Even though debt funds are less risky than equity mutual fund schemes, the risk levels vary among the various subtypes of debt funds. Acknowledging the risk and duration difference among the different types of debt funds is crucial before you decide to add them to your investment portfolio.

The following list outlines a few common types of debt funds available in India as per SEBI’s categorisation:

• Overnight funds: Overnight debt funds invest in securities with a maturity period of 1 day. These funds are highly liquid and relatively safe.
• Liquid funds: Liquid funds are another low-risk type of debt fund where investments are made into assets with a maximum maturity window of 91 days.
• Dynamic bond funds: These debt funds invest in securities across durations to leverage interest rate fluctuations which makes them riskier than liquid and overnight funds.
• Gilt funds: 80% of a gilt fund’s corpus is invested in government securities, ensuring almost zero default risks for investors.
• Corporate bond funds: These debt funds invest at least 80% of their pooled funds in investment-grade corporate bonds to offer good capital safety.
• Banking and PSU funds: As the name suggests, these debt funds primarily park their corpus in instruments issued by banks, PSUs, and other such entities.
• Credit risk funds: Credit risk funds are some of the riskiest debt funds because they invest in low-grade corporate bonds to secure higher returns against a high default risk exposure.
• Ultra-short duration funds: These debt funds invest in assets with a macaulay duration of 3-6 months.
• Short duration funds: Ideal for short-term goals, short duration funds invest in debt securities and money market instruments with a maturity of 1-3 years.
• Long duration funds: Long duration funds park their corpus in debt instruments with a maturity of more than 7 years, making them apt for long-term goals.

Note: This is not an exhaustive list of debt funds.

Now that you have a good overview on the different types of debt funds available in the market, you can proceed to understanding how to choose the right ones for your portfolio. Here’s a list of steps you can implement to understand how to choose the best debt funds for your portfolio:

Understand your investment horizon

Carefully evaluate your investment horizon and risk appetite before you add a debt fund to your portfolio. Start by outlining your investment goal. Setting a clear goal for your investment helps identify the appropriate time horizon and target amount. Different types of debt funds are suitable for different goals. For instance, short duration funds are ideal for short-term goals like foreign vacation plans that are still 1-3 years away. However, long duration funds are better for long-term goals like retirement. Considering your investment horizon is crucial when selecting a debt fund for your portfolio.

Evaluate the risks involved in types of debt funds

As mentioned earlier, different types of debt funds carry different risk quotients. In simple words, some debt funds are riskier than others. For instance, credit risk funds are riskier than gilt funds because they invest in junk bonds. Junk bonds have a low credit rating which means the issuer is more likely to default on the repayment obligation. A higher interest rate is offered as compensation for this heightened risk exposure. Gilt funds, on the other hand, invest primarily in government securities. Since the government is less likely to default on payment obligations, gilt funds are considered relatively safe investment options. When picking a debt fund for your portfolio, comparing mutual fund schemes is crucial to understand if the risk level of the fund coincides with your own risk profile. For instance, if you are a high-risk investor, a credit risk fund can be a good option. However, if you are a low-risk investor, sticking to liquid, gilt, and corporate bond funds may be prudent.

Learn about the credit rating of different debt funds

Debt funds are subject to credit risks, meaning the issuer of the underlying security can default on the principal or interest payment. While you consider the general risks associated with different types of debt funds, you must also understand the value of credit ratings when picking funds for your portfolio. Credit ratings given by agencies like CRISIL and ICRA range from AAA+ to D, with AAA+ being the highest rating. The higher the credit rating, the safer the fund. Debt funds that invest in securities with low ratings have a higher credit risk but also offer higher returns. So, you must decide on your return expectation and risk tolerance carefully before evaluating the different types of debt funds.

Assess the other risks associated with debt funds

While we’ve covered credit risk in detail above, there is another significant risk associated with debt funds - interest rate risk. It is the risk that interest rate fluctuations in the economy will impact the NAV (Net Asset Value) of the funds. Interest rates and NAV have an inverse relationship. Therefore, if interest rates rise, the price of existing bonds fall, resulting in a lower NAV and vice versa. Generally, this risk is more pronounced for long duration funds than short-term debt funds because interest rate fluctuations are more common and likely over a long-term horizon. In simple words, a fund with a longer weighted average maturity may be riskier than a debt fund that has a lower weighted average maturity.

Prioritise diversification

When evaluating the various types of debt funds, consider choosing ones that come with good built-in diversification. In other words, opt for funds that invest in a wide range of debt securities with varying maturities and risk levels. Additionally, implement the principle of diversification in your portfolio holistically. Instead of parking funds in any one debt fund, consider diversifying across equity and debt instruments with different MF schemes.

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• Ensure that the debt fund’s duration and risk match your investment horizon and risk profile.
• Liquid and overnight funds have low risk exposures, while credit risk funds carry a high credit risk.
• Utilise credit ratings and maturity duration to estimate credit and interest rate risks of the different types of debt funds.