Investing in Debt Funds: A Complete Guide to Low-Risk, Stable Returns

Debt funds are mutual funds that primarily invest in fixed-income securities such as government bonds, corporate bonds, and other debt instruments.

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First Published Oct 15, 2024, 4:48 PM IST | Last Updated Oct 15, 2024, 4:48 PM IST

Whether you’re looking to invest in mutual funds for the first time without taking excessive risk or are looking to diversify your equity portfolio to add relative stability, debt funds can be a suitable investment option for many.

But what exactly are debt mutual funds and what should you consider before investing in them?

This article takes a detailed look at this category and what role such funds can play in your portfolio

What are debt funds?

Debt funds are mutual funds that primarily invest in fixed-income securities such as government bonds, corporate bonds, and other debt instruments. A bond or fixed-income security essentially represents a loan given by the investor to an entity (such as a company or a government body). In return, the debtor agrees to pay a certain interest and repay the principal at maturity.

Unlike equity funds, which invest in shares of companies and can be extremely volatile, debt funds aim to provide relatively stable return potential.

Why invest in debt funds?

Potential for steady income: Debt funds have the potential to receive regular income through interest payments.
Lower risk: Generally, debt funds have a lower risk profile compared to equity fund while offering better return potential than traditional savings avenues.
Liquidity: Most debt funds allow you to redeem your investment quickly, providing easy access to your money when you need it.

Types of debt funds

Before you invest in debt funds, it's important to understand the various types available:

Overnight funds: Invest in overnight securities with a maturity of one day, with low risk and high liquidity, with potential to offer better returns than savings accounts.
Liquid funds: Invest in debt and money market instruments with a maturity of up to 91 days and offer high liquidity. They are low-to-moderate risk and can be used to build an emergency corpus, save up for a near-term goal or park surplus funds to potentially earn better returns than savings accounts.
Ultra short duration funds: Invest in debt and money market instruments. Portfolio Macaulay duration is three months to six months.
Low duration funds: Invest in debt and money market instruments with a portfolio Macaulay duration of six months to 12 months.
Money market funds: Invest in money market instruments with a maturity of up to 1 year.
Short duration funds: Invest in debt and money market instruments with a portfolio Macaulay duration of one year to three years.
Medium duration funds: Invest in debt and money market instruments with a portfolio Macaulay duration of three to four years.
Medium to long duration funds: Invest in debt and money market instruments with a portfolio Macaulay duration of four to seven years.
Long duration funds: Invest in debt and money market instruments with a portfolio Macaulay duration of more than seven years.
Dynamic Bond Funds: These funds actively manage their portfolios across durations based on interest rate movements.
Credit risk fund: Invest in corporate bonds that are rated below the highest credit rating, coming with higher return potential but increased risk.
Corporate bond funds: Invest primarily in company bonds.
Gilt funds: Invest primarily in government securities.
Banking and PSU fund: Invests in debt instruments of banks and public sector undertaking companies and public financial institutions.
Floater fund: Invests in floating rate instruments that have variable interest rates.

Generally, the longer the portfolio duration, the higher the risk and return potential.

Risks associated with debt fund investing

While debt funds are generally considered more stable than equity investments, they are not without risks. Here are some key risks to keep in mind:

Interest rate risk: When interest rates rise, the prices of existing bonds tend to fall. This can lead to potential losses if you need to redeem your investment during such periods.
Credit risk: This is the risk that the issuer of the bond may default on interest or principal payments. Thus, it's important to assess the creditworthiness of the underlying securities.
Liquidity risk: While most debt funds are liquid, there may be some closed-ended debt funds, so it is important to check if there is any lock-in period or exit load for your investments. Additionally, it is advised to align your investment horizon with the Macaulay duration of your debt fund category to mitigate interest rate risk.

How to invest in debt funds: Lumpsum or Systematic investment plan (SIP)

As the growth potential of debt funds is lesser than that of equity, a lumpsum investment can offer optimised return potential, especially in a favourable interest rate environment, because the entire investment gets market exposure from the start. However, Systematic Investment Plans or SIPs can spread out risk and make investing more affordable.

Therefore, the choice between lumpsum and SIP comes down to your investment goals and investing capacity.

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

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