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A to Z of Debt Mutual Funds

Table Of Content

Generally, people think that mutual funds only invest in the stock markets. Not many know that there are different types of mutual funds. A type of mutual fund is debt mutual funds. Debt funds invest in bonds which put simply are nothing but loans. In other words, debt funds give loans and collect interest. You get the interest of the loans as returns when you invest in debt mutual funds.

Types of Loans (Bonds)

Loans are mainly characterized by two factors:

a) duration of the loan, and

b) credit-worthiness of the borrower

Interest rates on loans are determined by the above two factors and the base rate set by the RBI and banks.

It is similar to when a friend asks you for money. You think about how likely he is to return the money (credit-worthiness) and how long is the money to be given for (duration). These two determine whether or not you will lend the money and at what interest. For a short duration like a year, you may give the loan without interest but for a long duration loan, you might want to charge the FD rate.

Higher Interest rate = Longer duration or riskier borrower or higher RBI rates

Similarly, longer duration loans typically carry a higher interest rate and so do loans to less credit-worthy borrowers.

So you can have loans that are (ultra short term, short term,

medium term, long term) given to (government, corporate, bank deposits). Almost all sorts of combinations exist and their risk-reward equation increases with duration and decreases with credit-quality of the borrower.

Debt Mutual Funds are characterized by the type of loans they

give/invest in.

A Debt Mutual Fund that primarily invests in loans that are of short, medium or long duration is called Short Term, Medium Term, or Long Duration Debt Funds. Additionally, if the Mutual Fund only invests in government bonds then it will be called a Gilt Fund.

A more complete list of Debt Mutual Funds categories is presented later below.

The risk-returns trade-off in Debt Funds:

Did you know that it is possible to make a loss when you invest in Debt Funds?

Risk-reward trade-offs exist in debt markets and debt mutual funds too (although the magnitude is lower). As they say, there are no free lunches.

The total returns of a debt fund comprise of the following,

  • Interest earned on invested securities

  • Capital gains – due to changes in the interest rates. Bond prices go up when interest goes down and vice versa.


Higher returns = higher risk even in Debt Funds

Credit Risk

Loans given to corporates will be riskier and of higher interest rates than those given to the government. Within corporates also different corporates have different credit-worthiness and there is an entire spectrum (think Tata vs Kingfisher Airlines). Loans given to companies with poor credit ratings will be even riskier and will correspondingly bear an even higher interest rate because there is a risk of default or delayed payments.

Duration Risk

Longer duration means less certainty on your repayments. Even though the credit rating of the borrower may be good today, it can change over time and you would be stuck with a bad loan then (this is how banks end up with Non Performing Assets). 

If in future the general interest rates increase, you will still be stuck with your lower interest-bearing loan. In other words, the net worth of your loan will go down as compared to the new loans of the same amount being issued at current interest rates.

On the flip side, if the general interest rates decline, you would be happily ‘stuck’ with your higher interest-bearing loan who’s net worth value will go up compared to the new loans being issued at current interest rates. 

So the value of a longer duration loan varies a lot with changes in interest rates set by RBI from time to time thus bringing volatility.

List of Debt Mutual Funds categories,

CATEGORIES OF DEBT MUTUAL FUNDS

Debt Fund
Category
Invests in Duration of
loans/bonds
Credit Risk Duration Risk Last 10 year
CAGR
Bad case
3 month returns*

Debt Funds taking low risk

Overnight Overnight
securities
1 day Lowest Lowest 7.06% 0.97%
Liquid Mostly Certificate of Deposits (CDs), Commercial Paper (CP), corporate debentures < 91 days Very Low Very Low 7.80% 1.01%
Ultra Short Duration Certificate of Deposits (CDs), Commercial Paper (CP), corporate debentures 3-6 months Low Low 7.99% 0.16%
Low Duration Fund Corporate bonds mainly, some CDs and CPs 6-12 months Low- Moderate Low 7.01% -0.07%
Money Market Fund Only CDs and CPs Upto 1 year Low Low 8.02% 0.51%

Debt Funds taking only duration risk

Floater Floating rate
corporate bonds
1-3 years Low Moderate
7.93% -1.02%
Banking and PSU Bonds of banks and PSU companies Any, 3-6 years Very Low High 8.44% -1.60%
Long Duration Mostly Govt and PSU Bonds, some corporate bonds > 7 years Low Very High 8.51% -1.56%
Gilt Govt. bonds only Any, usually 5-10 years Lowest High-Very High 8.65% -9.14%
Gift Fund with 10 year constant duration Govt. bonds only 10 years Lowest Very High 9.51% -4.24%

Debt Funds taking credit & duration risk both

Short Duration Mostly Corporate
bonds
1-3 years Moderate-High Moderate
7.43% -3.13%
Medium Duration Mostly Corporate bonds 3-4 years Moderate-High Moderate
7.36% -5.02%
Medium to Long Duration Mostly Corporate bonds 4-7 years Moderate-High High 7.64% -9.73%
Dynamic Bond Corporate and govt bonds Changes according to interest rate cycle Moderate Moderate-High 8.23% -3.04%
Corporate Bonds At least 80% AAA rated corporate bonds Any, usually 2-5 years Moderate High 7.86% -3.91%
Credit Risk At least 65% AAA rated corporate bonds Usually 1-3 years Highest Moderate
6.54% -3.08%

*Based on worst quarterly returns of some of the largest funds in this category as of 27th April, 2020



As you can see, the difference in returns between the safest debt funds (Overnight Funds/Liquid Debt Funds) and other more risky ones is usually positive.

That is although not by much – about 1-1.5% pa.

Liquid and Ultra Short Duration Funds seem to offer the best alternative to FDs without compromising on safety. Even in the bad case, they manage to eke out some positive returns over a quarter (they could still be negative in a particular week/month).

Medium Term, Long Term, or Gilt Funds give slightly higher returns in the long term but are more volatile in nature and are capable of giving negative returns over longer periods of time as compared to Liquid Funds. This can be seen from their bad case returns column in the above table. Long duration debt funds can give negative returns for an entire year also – as they did in 2009 when they lost about 10-15%.

Too much is it! Phew! Now at least you know where to put your money in. Niyo Wealth is here for the best experience with your investment. 

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