Know which types of debt funds to invest in and when

5 MinsOct 10, 2022

If you have a low-to-moderate risk appetite, an investment time horizon of three years or less, and are looking for mainly wealth preservation with modest returns, then you may consider investing in Debt Mutual Funds.

Know which types of debt funds to invest in and when

A debt mutual fund's primary goal is to generate a consistent stream of interest income as well as a modest appreciation by investing in such securities. The return potential of a debt mutual fund scheme depends on the environment in the debt market –– mainly the interest rate cycle (which determines where yields are headed) –– and the sub-category of the debt fund.

Debt Mutual Funds are categorised into the following sub-categories:

1. Overnight Funds–
These have a mandate to invest in overnight securities with a maturity of as low as 1 day. These are typically money-market instruments. They are a very low-risk-low-return investment proposition and are suitable to park money for a few days or weeks.

2. Liquid Funds –They are mandated to invest in money market instruments having a maturity of up to 91 days. These include instruments such as CDs, CPs, T-Bills, and so on. These offer the most liquidity and are least influenced by interest rate movements. On the risk-return spectrum, these tend to be at the lower end compared to other Debt Funds and are suitable to park money for a few months.

3. Money Market Funds –
These funds invest in money market instruments with a duration of up to 1 year. The instruments are mainly CDs, CPs, T-bills, Call Money, and so on. However, if they hold CPs, which are issued by private issuers, they may have some element of credit risk vis-à-vis if they hold CDs, T-bills and other money market instruments. If your investment horizon is up to a year, you may consider Money Market Funds.

4. Ultra-Short Duration Funds –
The maturity or duration of the portfolio of these funds is between 3-6 months. So, compared to Liquid Funds, they invest in higher maturity debt papers and money market instruments. As the maturity profile of the debt papers is slightly higher, the risk of investing is also a bit higher compared to a Liquid Fund. You may consider them if your goals are a few months away, but check the quality (i.e., ratings) of papers held to check the risk involved. 

5. Low Duration Funds –
This fund typically holds a portfolio duration of 6 to 12 months. Hence, what changes is the maturity profile and type of the debt paper held. A low-duration fund may be riskier than ultra-short duration funds in terms of risk-return, and thus is appropriate for a slightly longer time horizon of a year or more.

[Also Read  Include a mix of asset classes in your investment portfolio]

6. Short Duration Funds –
These funds are mandated to hold a portfolio duration between 1 and 3 years. Typically, they may invest in a variety of debt papers, corporate bonds/debentures, government securities and money market instruments to earn better yields. But the risk involved is higher than with a Low Duration Fund. Invest in them with an investment time horizon of around 1 to 3 years.

7. Medium Duration Funds –
The duration of these funds, as per their mandate, is between 3 and 4 years. Thus, the maturity profile is longer and with possibly higher-yielding debt papers viz. corporate bonds/debentures, government securities, etc. If you have a slightly higher risk appetite and an investment horizon of 3 to 4 years, these funds may be suitable for you. 

8. Medium to Long Duration Funds –
The duration of the portfolio of these funds is between 4 and 7 years. Since it invests in a variety of debt papers for better yields, the maturity profile is higher compared to a short duration and medium duration. Hence this sub-category of a debt fund is a moderate-to-high-risk investment proposition. In a rising interest rate scenario, the risk could get accentuated for Medium to Long Duration Funds as they may witness extreme volatility but the returns clocked may be limited.  

9. Long Duration Funds –
Here the duration of the portfolio is more than 7 years while investing across debt papers. Again, in a rising interest rate scenario, a Long Duration Fund may expose its investors to high risk. Hence, it may not be suitable for all investors, particularly if you are addressing long-term financial goals.

10. Dynamic Bond Funds –
These funds have the flexibility of investing in debt securities of varying maturity buckets based on interest rate scenarios and the macroeconomic outlook of the fund manager. Therefore, a Dynamic Bond Fund could move into short-term instruments, such as CDs, CPs, corporate bonds, gilt securities or long-term instruments, depending on their outlook on interest rates and the overall economy.

11. Corporate Bond Funds –
These funds invest a minimum of 80% of assets in high-quality corporate bonds rated AA and above. The duration of the portfolio is not defined, so the maturity profile of every Corporate Fund Bond would be different. But typically, they have a maturity profile of 2 to 3 years. Before investing in Corporate Bond Funds, always check their portfolio characteristics to get a picture of the kind of instruments they hold. 

12. Banking and PSU Funds –
They are mandated to invest at least 80% of assets in debt securities issued by PSUs, PFIs and banks. The duration could be diverse. If you have an investment time horizon of 2 to 3 years and wish to take exposure mainly to government securities, these funds could be an appropriate choice. In comparison with Corporate Bond Funds, Credit Risk Funds and medium duration funds, the Banking & PSU Funds are expected to expose you to low risk.

13. Credit Risk Funds –
These are high-risk-high-return investments, as a minimum of 65% of their investible corpus is invested in low-rated (below AA) corporate bonds. The fund manager takes the credit risk and engages in yield hunting. Depending on the type of debt papers they hold and the maturity profile, Credit Risk Funds attract a certain degree of risk.

14. Gilt Funds –
They carry zero credit risk as a minimum of 80% of their investible corpus is invested in sovereign-rated government-backed securities, which could be issued by the central or state government. But the returns depend on the interest rate scenario. In a rising interest rate scenario, where yields are moving up, the return potential of a Gilt Fund is usually limited. It is best suited if you have a longer time horizon (of around 3 to 5 years) and when interest rates in the economy are expected to fall.

15. Gilt Fund with 10-year Constant Duration –
This is a variant of Gilt Funds, which is mandated to invest in government securities such that the duration of the portfolio is equal to 10 years. Thus, unlike the above, the maturity profile of this variant of Gilt is well-defined. On a risk-return basis, they are comparable to the usual Gilt Fund. A rising interest rate scenario could weigh down the performance of the Gilt Fund with a 10-year Constant Duration.

16. Floater Funds –
As per the mandate, these funds invest a minimum of 65% of their corpus in floating rate instruments. They carry low risk and are less vulnerable to changes in the interest cycle, because these funds, typically hold low maturity floating rate instruments. These could include securities such as government securities, floating rate debentures, Non-Convertible Debentures (NCDs), CPs, CDs, zero-coupon bonds, etc. To mitigate the interest rate risk and a holding period of 1 to 2 years, Floater Funds may be considered.

If you are willing to earn a market-linked return and assume some risk Debt Mutual Funds can be an option for you. 

When you invest in Debt Mutual Funds, don’t assume them to be safe or risk-free. There is interest rate risk, credit risk and re-investment risk involved. Hence choose debt funds carefully. You can select a Debt Fund suitable for you online. 

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision

Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. *T&C apply