What are the Different Types of Debt Funds?

Debt mutual funds are extremely popular among investors. They offer superior returns and tax benefits. But there are 16 different types of debt funds in India. Each type has a unique investment objective and risk profile.

Hence before investing, investors must understand the different types of debt funds and how to use them for creating an all-weather debt fund portfolio.

In this article we cover

• 1) Types of Debt Funds Based on Maturity Period

• 2) Types of Debt Funds Based on Lock-in Period

• 3) Types of Debt Funds Based on Type of Borrower

• 4) Types of Debt Funds Based on Risk

The 16 different types of debt funds can be segregated based on the following:

• Maturity Period
• Lock-in Period
• Type of Borrower

Types of Debt Funds Based on Maturity Period of Underlying Papers.

Debt mutual funds invest in various debt instruments like Bonds, Debentures, Treasury Bills etc. All these underlying papers have an expiry date which is known as ‘maturity’.

Based on maturity, debt funds can be divided as –

Short Term Debt Funds

are funds which invest in papers maturing between 1 day and 3 years. Short Term Debt Funds are further divided into the following –

1. Overnight Funds:

These funds invest in debt securities maturing in 1 day. They typically invest in call money instruments issued by banks

Overnight funds carry almost zero risk but also offer very low returns. They are perfect if your holding period is a few days or weeks. These funds are highly liquid as they have no exit load.

2. Liquid Funds:

Liquid funds invest in papers maturing within 91 days. They typically invest in Treasury bills, Commercial Papers and Certificates of Deposits.

They provide slightly higher returns than overnight funds. Liquid funds have an exit load period of 7 days post which investors can redeem anytime. Liquid funds investing in government papers are highly safe.

[ Read More: 5 best Liquid Mutual Funds for 2021. ]

3. Ultra-Short Duration Funds:

Ultra-short duration funds invest in debt and money market instruments maturing in 3-6 months.

4. Low Duration Funds:

Low Duration funds invest in debt securities maturing in 6 - 12 months. Low risk debt funds are suitable for conservative investors with less than 1 year time horizon.

5. Money Market Funds:

Money Market Funds invest in instruments having maturity of less than 1 year. Money market instruments include:

• Treasury Bills
• Certificate of Deposits
• Commercial Papers

6. Short Duration Funds:

Short term debt funds have the freedom to invest in debt instruments maturing in 1-3 years. Short term debt funds are popular during rising interest rates.

The below graph shows the Returns of different types of short term debt funds in the last 10 years

10-year returns of Different types of Short Term Debt Funds

Medium Term Debt Funds

Medium term debt funds invest in instruments maturing in 3-4 years. These funds carry medium-high interest rate risk. Hence they are suitable for only medium risk investors with 3-5 years investment horizon.

Medium to Long Duration Debt Funds

Medium to long duration debt funds invest in debt securities maturing in 4-7 years. These funds experience high interest rate risks. Only investors with medium – high risk profile and a long time horizon should invest in medium to long duration funds.

Long Duration Debt Funds

Long duration debt funds invest in debt instruments maturing in more than 7 years. They carry very high interest rate risk. Long Duration funds are popular during falling interest rates. Aggressive investors with a long term horizon (7+years) should invest in long duration debt funds.

Dynamic Bond Funds

Dynamic bond funds have the flexibility to invest in both short term and long term debt papers. They react aggressively to changes in interest rates. Unlike corporate bond funds, dynamic bond funds can invest in papers across credit ratings. Hence they carry high credit and interest rate risk.

Floating Rate Funds

These funds can invest up to 65% of the corpus in floating interest rate instruments. They carry high risk as fund managers often invest in papers with low credit ratings. Hence only investors with a high risk profile and long investment horizon should invest in floating rate funds.

[ Read More: Major Types of Risks in Debt Funds ]

Types of Debt Funds Based on Lock-in Period

Based on lock-in period, debt mutual funds can be divided as:

• Open ended funds
• Close ended funds

Open Ended Debt Funds:

Majority of debt funds are open-ended. This means that an investor can buy and sell units anytime without any restrictions. These funds offer highest liquidity as they can be redeemed as per daily NAV. Ideally investors should invest in open-ended debt funds only.

Close Ended Debt Funds:

close ended debt funds such as Fixed Maturity Plans (FMPs) have a fixed maturity date. You can invest in these funds only during the NFO open period and redeem only on maturity. These funds are listed on the stock exchange, but have very little liquidity.

Types of Debt Funds Based on Type of Borrower

Your debt mutual fund collects money from various investors. This ‘pooled’ money is then invested in debt securities issued by various borrowers. Based on the type of borrower, debt funds can be divided into:

1. Corporate Bond Funds:

Corporate bond funds invest in securities issued by corporates (private companies). Since the fund lends to private companies, they do face credit risk. But as per SEBI’s mandate, Corporate Bond Funds must invest a minimum 80% of their corpus in AAA rated papers. Hence corporate bond funds are safer than dynamic bond funds.

2. Gilt Funds:

Gilt funds invest in securities which are issued by Central or State governments. These funds have zero credit risk but high interest rate risk. There are two types of gilt funds –

• Across Maturities Gilt Funds (Short-term gilt funds)
• Constant 10-year maturity Gilt Funds (Long-term gilt funds)

Short term gilt funds are suitable during rising interest rates. Long term gilt funds are suitable during falling interest rates.

3. Banking & PSU Debt Funds:

These funds invest at least 80% of the ‘pooled’ money in debt securities of banks, public sector undertakings (PSUs) and public financial institutions. These funds carry low credit risk and are suitable for conservative investors.

Types of Debt Funds Based on Risk

Investors believe that all debt funds are risk-free. But this is not true. Credit risk, a type of debt fund carries very high risk. This fund is suitable for ‘aggressive’ investors only.

Credit risk funds invest up to 65% of their corpus in securities with low credit ratings. These make them extremely prone to defaults. In India, credit rating is given to agencies such as CRISIL, ICRA and CARE.

A credit rating of AAA means the papers are highly stable. D means the papers have high chances of default. While credit risk debt funds do not invest in D rated papers, they do invest in below AAA rated papers, which are less stable. The perfect alternative for credit risk funds is investing in Corporate Bond Funds. Corporate Bond Fund majorly invests in AAA rated papers only. You can also invest in gilt funds.

Investing in only one type of debt fund is not recommended. Investors should instead try to build an all-weather debt fund portfolio. An ideal debt portfolio should consist of all three types of debt funds – Short term, Medium term and long term.

The best way to build an all-weather debt fund portfolio is by matching your risk profile and time horizon to the maturity of debt fund papers. The below grid will help you decide which type of debt fund to invest in.

We understand that creating an all-weather debt fund portfolio can be a scary task. This is where RankMF’s Mutual Fund Baskets come in handy. You can invest in all the best debt funds in India under 1 single basket. This basket is managed by RankMF experts with periodic rebalancing.

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