What are the types of debt mutual funds and their risk classification?
Types of Debt funds, Debt funds, types of debt funds, dynamic bond funds, liquid funds
Debt funds are a type of actively managed mutual fund that primarily invests in debt instruments such as Treasury bills (T-bills), Government securities (G-secs), commercial papers (CP), government and corporate bonds, certificates of deposit (CD), and money market instruments.
What are the different types of debt funds in India?
This type of debt fund is considered relatively less risky among mutual funds. As the name suggests, they are liquid and allow investors to redeem and liquidate their investments depending on their needs. The portfolio of this fund comprises instruments that have a short maturity period of not exceeding 91 days.
Dynamic Bond Funds:
Dynamic Bond Fund is where the fund manager dynamically changes the maturity of the portfolio depending upon the interest rate forecast. If the forecast indicates a rising interest rate, then the fund manager may opt for instruments with a longer maturity. If the forecast is indicating a falling interest rate, then the fund manager opt for investments in instruments with a shorter duration of maturity.
Short / Medium / Long Term Debt Funds:
Short-term Funds are a type of debt fund that generally have a maturity period of 1 to 3 years. The portfolio of short-term funds is structured in a way such that their prices are not much impacted by the interest rate movements.
Medium Term debt funds generally have a maturity period of up to 3 to 5 years, and long-term debt funds have a maturity exceeding 5 years. The longer the tenure, the more significant is the impact of the interest rate on the portfolio, which is also known as interest rate risk or duration risk.
Fixed Maturity Plans
This type of debt mutual fund is a closed-ended scheme. However, they can be traded on the stock exchange where they are listed.
Investment in debt mutual funds are generally less volatile than equity mutual funds. However, there are different types of risks in debt funds.
AMFI has very well-articulated the risks present in Debt Securities. Let us take a brief look at the risks prevalent in the debt market instruments.
Interest Rate Risk
The NAV or Net Asset Value of Debt Mutual Funds is inversely related to interest rate movement. Generally, when the interest rates rise, the prices of existing fixed income securities in your debt mutual fund portfolio fall and when interest rates drop, such prices increase. Accordingly, the NAV of the debt mutual fund portfolio may fall if the market interest rate rises and may increase when the market interest rate comes down. The extent of fall or rise in the prices depends upon the duration or maturity of the underlying security.
Credit risk refers to the risk associated with default on interest and /or principal amounts by issuers of fixed income securities. The credit rating agencies assign a credit rating to fixed income securities and accordingly, in case of a default, the debt mutual fund may not fully receive the amount due to them and the NAV of the scheme may fall to the extent of default. The price of a security may change with expected changes in the credit rating of the issuer, even when there is no default. It may be mentioned here corporate bonds may carry a relatively higher amount of credit risk than government securities. Within corporate bonds too there are different levels of safety.
Liquidity risk refers to the ease of selling debt instruments at or near their valuation yield-to-maturity (YTM) or true value. Liquidity condition in the market varies from time to time and accordingly, the liquidity of a bond may change, depending on market conditions
Assess the illiquidity of the underlying securities of the debt mutual fund portfolio. At the time of selling the security, the security may become illiquid, thereby leading to a loss in the value of the portfolio.
Debt funds are suitable for investors having a lower appetite for risk. Be cognizant of the underlying risk in the portfolio before you invest.