Debt mutual funds are a category of mutual funds that invest primarily in fixed income instruments (example bonds) issued by government, public and private companies. Or simply you can understand that the money you put in a debt mutual fund, is in turn lent out to private/public companies or government bodies. Mutual funds get interest from these borrowers which is reflected in the returns of the mutual fund.
From a layman’s perspective, debt funds are construed as risk-free, this is because of the lack of awareness about debt funds. Many invest in debt funds considering their capital to be protected like money lying in a savings a/c or a fixed deposit. This is not entirely true, there are different risks involved in debt funds that should be understood before investing. However, these risks do not put forth a case for not investing in debt funds – if one invests by carefully understanding the associated risks and follows his/her asset allocation, these risks can be mitigated.
There are three kinds of risks involved in debt funds – as explained hereunder:
1. Credit Risk
Mutual Funds lend the money, they receive from the investors, to the Government, Banks and Companies (both private and public). Now, highest credit risk accrues from companies and least from government. Borrowing companies can get financially distressed or bankrupt going forward and can delay or fail to pay the interest/principal – this risk of not repaying the accrued interest/principal on time is credit risk. There could be an exception of government or bank going bankrupt but that is very rare.
2. Liquidity Risk
Mutual Funds do not always hold the debt securities till maturity, and sometimes they sell it prior to maturity. This can be due to various reasons like redemption pressure, in anticipation of rise in interest rate or falling credibility of the borrower, more attractive opportunity, etc. Now the risk of not being able to trade any debt security quickly enough in the market without impacting the market price is the liquidity risk. This can be due to both micro and macro reasons (mostly macro). Macro reasons like market depth or during the time of turmoil in economy, high-yielding (junk bonds) securities see lack of takers at its fair value. Micro reasons can be unfavorable characteristics of bond (like interest rate, horizon, company specific news, etc.) which may make it less liquid.
3. Interest Rate Risk
This is one of the most important risk factors and needs to be understood clearly. Bond prices and interest rates are inversely proportional to each other. If the interest rate goes up in the market, existing bonds become less desirable and trade at discount to compensate and match the market yield, and vice versa.
Further, longer the duration of the bond, greater the interest rate risk. For eg: in rising interest rate environment, price of the bond with longest duration will fall the most (because they have already locked in their coupon rate for a specific horizon which is lower than prevailing market rate) and vice versa.
However, not all debt funds have all these three risks (as mentioned above). There are 16 categories or types of debt funds. Let us understand which of them carries any or all of these risks.
| Debt Fund Type | Credit Risk | Liquidity Risk | Interest Rate Risk | Duration |
| Overnight Fund | Negligible | No | No | 1 Day |
| Liquid Funds | Negligible | Negligible | Negligible | <90 Days |
| Ultra Short Term | Yes | Yes | Negligible | 3-6 Months |
| Low duration | Yes | Yes | Yes | 6-12 Months |
| Money Market | Yes | Yes | Yes | <1 Year |
| Short Duration | Yes | Yes | Yes | 1-3 Years |
| Medium Duration | Yes | Yes | Yes | 3-4 Years |
| Medium-Long Duration | Yes | Yes | Yes | 4-7 Years |
| Long duration | Yes | Yes | Yes | >7 Years |
| Dynamic Bond | Yes | Yes | Yes | Varies |
| Corporate Bond | Yes | Yes | Yes | Varies |
| Credit Risk | Yes | Yes | Yes | Varies |
| Banking & PSU | Low | Low | Yes | Varies |
| Gilt Fund | No | Low | Yes | Varies |
| Gilt Fund-10 year constant duration | No | Low | Yes | 10 Years |
| Floater Funds | Low | Low | Low | Varies |
Conclusion
The above table is just to give you a broad idea at category level. Any category having all three types of risk does not mean that it is a bad category – Invest-worthy funds always exist in each category. Never look just at the past performance in case of debt funds. Credit quality, interest rate scenario forecast, company specific news, and much more subjective analysis is to be done before investing in a debt fund. We have seen good credit quality funds delivering double digit returns, as well as funds doing complete disaster and eroding the corpus – so we cannot brush the entire debt fund category with the same brush.
RIGHT Debt funds must be a part of one’s portfolio but the category composition and extent completely depends on one’s risk profile and investment objectives.
You may reach us at mf@ontrustcap.com – in case you have any queries on debt mutual funds or wealth management in general. We shall be glad to assist you.