In this article, we will go over the aspects of debt funds including their types, and why they are considered relatively low risk options for income generation. Investors who prefer a steady stream of income without taking on too much risk debt funds are a good option.

What are Debt Funds?

Rather than actively managed stocks, debt funds invest in interest earning assets such as bonds, making them a type of mutual fund. For those who wish to avoid the risk associated with equity markets, debt funds are the right investment option. Debt instruments include:

State Bonds

Tradable Bank Fixed Deposits

Corporate Fixed Deposits

In comparison to the equity funds which are dependent on performance, debt funds invest in more reliable instruments, thereby making them take less risk.

Categories of Debt Funds

These categories are based on the particular features of the debt fund, for example duration, investment level, type of risk, or instrument type.

1. Category of Investment Based on Duration Duration identifies the maturity period of the relevant debt instruments within the Portfolio. The investment duration describes the following categories: Long Term- 7+ years Medium Term- 4 to 7 years Short Term- 1 to 3 years Money Market- Up to 1 year Low Duration- 6 to 12 months Ultra Short Term- 3 to 6 months Liquid Funds- Up to 91 days Overnight Funds- 1 day Dynamic Bond Funds- Open-ended (flexible) maturity periods.
2. Category of Investment Based on Risk Debt funds (bonds) can be classified according to the level of risk they carry. Credit Risk Funds: These funds invest in low-rated bonds AA or lower rated bonds because they have higher risk and potentially yield greater returns. Safe Funds: These bonds are put out by well-rated institutions (AAA or higher), tend to have lower risks and relatively stable yields.
3. Primary Instruments of investment The following includes primary investment for debt funds: Corporate Bond Funds: These funds put at least eighty %(80%) of their capital in bonds with AA rating or higher. Banking & PSU Funds: These funds primarily invest in bank and zonal public sector and municipal bonds. Gilt Funds: These invest in government securities which are considered having great faith.
4. Open And Closed Funds

Debt funds vary greatly in how they are structured for investments. For example, Fixed Maturity Plans (FMPs) are closed-ended funds with a fixed lock-in period. It works similarly to a bank FD but is much more limited in withdrawal.

Roll Down Strategy Funds on the other hand are flexible funds where one can add or withdraw money. The fund manager works to help minimize interest rate risk by decreasing the duration of the porfolio over time.

Open Ended Funds on the other hand can be traded freely, bought and sold at any point in time. They also give the option of Systematic Investment Plans/SIPs and Systematic Withdrawal Plans/SWPs for further customizations.

How Would One Go About Selecting A Debt Fund For Investment

While choosing the best debt fund, it is important to consider the following factors:

Risk Appetite

Moderate Risk:

Funds that have a duration or credit risk

Low Risk:

Banking and corporate bond funds

Minimum Risk:

Ultra-short term funds or low-duration funds

Affordability of Fluctuation Volatility

If you are sensitive to market fluctuations, ultra-short-term funds would be the best option as it comes with little to no market volatility risk. On the contrary, credit risk funds tend to have higher market risk, thus experiencing greater volatility.

Type Of Investment

For Fixed Maturity:

If you do not expect to make a withdrawal before maturity, then you should invest in FMPs.

For Safety:

Gilt funds, corporate funds, as well as banking/ PSU funds are a little safer than the rest of the options available.

For Flexibility:

Funds using a roll-down strategy are good, as they let you take out funds without being locked in for a set period.

Best companies in asset management (AMCs) for handling Debts funds.

Here is a collection of the most popular Asset Management Companies (AMCs) which are famous for their debt fund management:

ICICI Asset Management
Axis Asset Management
IDFC Asset Management
HDFC Asset Management
CR Asset Management

They are best known to manage funds with great focus on risk control and overall performance.

Key Takeaways

Invest in debt funds when you want low risk and a steady return.

Ultra-short-term or low-duration funds will work best for low risk.

Select a debt fund depending on your level of comfort with risks and the level of changes you can afford.

Roll-down maturity funds increase flexibility and lower interest rate risk with time.

Pooled mutual funds (FMPs) should be chosen for your funds if you do not need access before the pre-defined maturity date.

When you chose the most appropriate debt fund and did so according to the investment goal, it is possible to build a balanced portfolio that has low debt risk and high potential income.