When it comes to mutual fund (MF) investing, most people assume equity is the only way to go. But there is a range of debt funds with varying degree of risks and time-frames to invest. Debt funds work on the principal of traditional debt instruments such as bank fixed deposits, small savings schemes and other bonds that provide a fixed interest payout. Debt funds invest in debt or fixed income securities of various corporate institutions and the government and are also known as income funds. But this doesn’t mean that debt funds are immune to ups and downs or guarantee fixed returns like, say, FDs.
Many of the instruments debt funds invest in, such as corporate bonds, PSU bonds, debentures, commercial papers, treasury bills etc. are not always open to individual investors. Debt funds play the role of a facilitator to invest in a diverse universe of debt instruments that require intricate investing knowledge. Moreover, unlike traditional debt instruments, debt funds invest in tradeable debt instruments in the market segment where such trades occur, making them earn superior returns compared to a standard FD.
Debt fund structure
There are a few compelling reasons to invest in debt funds—diversification among the universe of debt instruments, superior returns, liquidity and tax efficiency being a few. These also provide the convenience of mutual fund investing by way of investing small regular sums to suit an investor’s financial needs and suitable time-frame. At the same time, debt funds also carry risks like any other financial instrument (see Debt Fund Risks).
Debt Fund Risks
Interest Rate: They are not static, and can rise and fall. Also, interest rate and portfolio values (NAV) move in opposite directions, which means when interest rates fall, NAVs go up and vice versa
Credit Risk: This is about the bond issuer not returning the coupon income and/ or maturity proceeds on the specified dates as mentioned in the bond. No such risk in funds that invest in government securities
Liquidity Risk: This happens if the bond is not tradable at fair value or faces major redemption in adverse market conditions
For the sake of investors, market regulator SEBI introduced a comprehensive categorisation exercise under which debt funds are defined, including the kind of securities they can invest in (see Debt Fund Universe). With the standardisation, comparing and choosing a fund has become easy for investors. There are funds in which one could invest for as less a day to a week to those that cover over five years.
Source: SEBI categorisation & rationalisation
How to invest in debt funds
Debt funds primarily follow two different strategies to earn returns—accrual-based and duration-based—and both involve different roles and risks. For instance, in case of accrual strategy, the focus is to generate returns from interest income by managing credit risk, while minimising interest rate risk.
In this approach, securities held by the fund are held till maturity, which is followed by shorter maturity funds. Duration-based strategy focuses on capital appreciation by way of rise in price of the underlying bond due to fall in interest rate. The focus is not interest income but the way the bond price will move owing to interest rate changes. In such funds, investments are generally in long-term debt instruments where the interest rate risk is managed. Such a strategy is mostly followed by longer duration funds as well as gilt funds.
When investing, it is important to define one’s investment time-frame (see A Suitable Fund). For instance, if your need is to park money for a few weeks or months, an overnight fund or liquid fund is suitable compared to, say, a gilt fund. Finally, fund selection should be based on its pedigree, past track record, the corpus it manages, and the fund manager’s experience.