Debt Funds

What are Debt Funds & Types of Debt Funds.

If you are new to the world of investing and looking for options, it is better that you take some time out and first identify the primary purpose of your investment. That’s because the financial industry is swamped with the end number of investment products, catering to the needs of almost every individual. Thus, having a realistic goal be it short term / long term, might help an investor in choosing an investment that may hold the potential to support their investment objective.

Understanding one’s risk tolerance is equally essential because the schemes available in the market vary according to the amount of risk they carry. Although it is true that no investment is considered to be risk free investment, you might be able to decide at least whether you want to settle with nontraditional investment methods or opt for a more aggressive approach through investments like mutual funds.

What are mutual funds?

Securities and Exchange Board of India or SEBI, the governing and regulatory body for mutual funds in India describes them as, “A mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in the offer document.

Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money invested by them. Investors of mutual funds are known as unitholders.

The profits or losses are shared by the investors in proportion to their investments. The mutual funds normally come out with a number of schemes with different investment objectives which are launched from time to time. A mutual fund is required to be registered with Securities and Exchange Board of India (SEBI) which regulates securities markets before it can collect funds from the public.”

To simplify the same, what mutual fund houses do is that they collect money from investors sharing a common investment objective and invest this pool of funds in marketable securities of companies across the Indian economy. Depending on the type of scheme, the money is invested in various assets, including equity, debt, treasury bills, government securities, corporate bonds, etc. Mutual fund owners shares in the form of mutual fund units. These units are assigned to the unitholder depending on the fund’s existing net asset value or NAV.

The term mutual fund is quite broad, and there are subcategories which distinguish funds depending on several attributes like the fund’s investment objective, fund size, investment strategy, risk profile, asset allocation, etc. While most individuals consider equity mutual funds to be the only mutual fund category, what a lot of people miss out on is that there are other mutual fund categories as well, which may be considered for investment. These include debt mutual funds.

This article is all about debt mutual funds and the type of debt mutual funds on offer.

What are debt funds?

While equity mutual funds predominantly invest in equity and equity related instruments, debt mutual funds invest in debt instruments. These funds invest in fixed income securities like treasury bills, call money, debentures, government securities, and corporate bonds which have a maturity date of up to 91 days. A lot of people consider debt funds to meet short term goals like making the down payment of their new car, renovating their home, planning a vacation, etc. However, there aren’t any hard and fast rules which says that you need to invest in debt funds only to meet short term financial goals. If you wish, you can remain invested in debt funds until your investment objective is met.

Types of debts funds

Debt mutual funds are further categorized depending on their risk profile and investment horizon. They are mentioned below:

Overnight fund: Overnight debt funds invest in securities which have a maturity of just one day. These funds are usually considered by investors, maybe for parking their emergency fund or medical expenses fund. This is an open ended scheme which invests in overnight securities.

Liquid fund: Axis Liquid Fund is a type of debt funds which predominantly invest in debt and debt related instruments. This is an open ended scheme which invests in marketable securities that come with a maturity period of up to 91 days.

Ultra short duration fund: Ultra low duration fund is an open-ended slow duration debt scheme which invests in securities having the Macaulay duration between 3 months and 6 months.

Low duration fund: Low duration fund invests in debt and money market instruments such that the Macaulay duration of the portfolio is between 6 months to 12 months. This is an open-ended low duration debt scheme available for investors.

Money market fund: A money market fund is a debt fund sub category that invests only in liquid instruments such as commercial paper, high credit rating debt-based securities, treasury bills, cash and cash equivalent securities, which have a maturity period.

Short duration fund: Short duration fund is an open ended short term debt scheme which invests in marketable securities with Macaulay duration between 1 year and 3 years.

Medium duration fund: This is an open ended short term debt scheme which invests in debt and debt related instruments with Macaulay duration between 3 years and 4 years.

Medium to long duration fund: Medium duration fund is an open ended short term debt fund which invests in debt securities which have a Macaulay duration between 4 years and 7 years.

Long duration fund: Of its total assets, a long duration fund must invest in debt and money market instruments such that the Macaulay duration of the mutual fund portfolio is longer than 7 years.

Dynamic bond: A dynamic bond is an open ended debt fund that switches between long-term to mid-term to short-term securities depending on the performance of the fund in the market.

Corporate bond fund: A corporate bond fund is an open ended debt scheme which primarily invests in highest rated corporate bonds.

Credit risk fund: In order to meet its investment objective, a credit risk fund must invest a minimum of 65 per cent in corporate bonds of the total assets. However, there is no guarantee that the fund will achieve its investment objective.

Banking and PSU fund: Of the total assets, a banking and PSU fund must invest a minimum of 80 per cent in debt instruments of banks, public sector undertakings, and public financial institutions. This is an open ended scheme available for investors of all types.

Gilt fund: A gilt fund is a type of a debt fund that must invest 80 per cent of the total assets in government securities in such a way that the Macaulay duration of the mutual fund portfolio equals to 10 years.

Floater fund: Of its total assets, a floater debt fund must invest a minimum of 65 per cent in floating rate debt instruments.

There are a few things that one must consider before investing in debt funds:

Investment objective

Each debt fund shares a unique investment objective, and hence it is better that you invest in a fund whose investment objective matches your expectations. The risk profile that every debt fund carries varies depending on the assets they invest in this too should be taken into consideration which choosing a suitable debt fund. Also, as we said earlier, set a realistic financial goal and that shall help you narrow down to a suitable scheme.

Investment horizon

The Investment horizon is nothing but the number of years one chooses to remain invested in order to get closer to their ultimate financial goal. Although debt funds invest in fixed income securities, these can be clubbed with equity investments for meeting long term goals. But investors have to make sure that the fund is credible enough and reliable enough to remain invested for the long run.

Track record of the fund

If you wish to find out the credibility of a particular debt fund, you must do a background check of the fund, which might help you with data for interpretation. There are few things which you track like the size of the fund, how long the fund has been in the market, how the fund is performing compared to its peers, whether the fund has managed to outperform its benchmark in the past, etc. But investors should bear in mind that the past performance of a fund may or may not reflect on its present and future performance.

Fund management

Just like choosing the right debt fund is essential; choosing a debt fund offered by a reputed AMC or fund house is equally essential. Investing in a debt fund that is handled by reputed management is always a sensible decision. The market performance of a debt fund kind of depends on the fund manager handling the fund. Also, a reputed AMC is usually equipped with all the necessary analytical and research tools which might add to the AMC’s reliability. This, it is better that you consider investing in a debt fund which is offered by an established and reputed fund house or AMC and is under the watch of a professional and experienced fund manager.

Expense ratio

Every mutual fund has some recurrent expenses which the fund house levies upon investors as annual fees for owning the deb fund. This fees charged to the investor is known as expense ratio and usually consists of several cyclical costs such as management fees, trustee fees, distributor commissions, etc. A fund with a high expense ratio might affect an investor’s long term gains, and they might end up paying more to the fund house than gaining any returns for themselves. Hence it is advisable that one takes the fund’s expense ratio into consideration before investing in any debt scheme.

Fund manager

Just like investing in a reputed fund house is vital, it is also necessary to find out the fund manager / managers involved in managing the fund. It is the duty of the fund manager to buy / sell securities with the intention of meeting the scheme’s investment objective. Hence it is necessary that the fund manager handling your fund has rich industry experience. After all, it is your hard earned money which you are entrusting in someone’s hand and hence, take this factor into consideration as well.

Exit load

Exit load means the fee charged by the asset managed company on the investor while withdrawing or redeeming their fund units. If a debt fund has a higher exit load, it might affect the redeemer, especially if he / she is redeeming the mutual fund units shortly after investing. However, if you remain invested for the long run, you may or may not have to worry about the exit load.

Growth and IDCW option

Debt mutual funds are available in growth and IDCW option:

Growth option: In growth option, the profits made by the debt fund are reinvested in the fund. This option might be viable for those individuals who wish to remain invested in the fund for the long run. That’s because this cycle of reinvestments of profits, over the long run, tend to increase the NAV or net asset value of the fund, which in turn may prove beneficial for unitholders.

IDCW option: If you are considering debt mutual funds for income sake, you might want to consider the IDCW option. Investors have the option of opting for periodical payouts. In this case, the IDCW offered to investors are deducted from the fund’s NAV. However, the intervals at which the fund manager may declare IDCW are uncertain and only happens if the fund manages to make any profits.

If you want to give your debt fund investments a systematic approach, you can consider investing in debt funds through SIP investment option. Systematic Investment Plan or SIP is an electronic payment method where the money is transferred from an investor’s bank account and transferred to their debt fund. If one continues to invest in debt funds via SIP for a long time, they stand a chance of benefiting from the power of compounding. 

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

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