What are Debt-oriented Mutual Funds: Meaning, Types, Benefits, and FAQs

Debt is one of the main asset classes that investors can consider to diversify their investment portfolio in addition to equities. One of the most efficient ways to Investment in debt instruments is via well-managed Debt-oriented Mutual Funds as they are less volatile than equities and facilitate steady growth of capital.

What are Debt Mutual Funds?

Debt Mutual Funds are schemes that predominantly invest (investing a minimum of 65% of their assets) in fixed-income generating instruments such as corporate bonds, government bonds, certificates of deposits, treasury bills, etc. These funds aim to provide diversification and stable returns as they are less volatile compared to equity mutual funds. This makes debt mutual funds suitable for investors with low-risk profile and a short to medium-term investment horizon.

[Read: 5 Best Low-Risk Mutual Funds to Invest in 2023]

The prevailing interest rate environment is one of the most crucial factors that affect the performance of a debt mutual fund. Apart from this, the credit quality and the maturity of the underlying securities in the portfolio can impact their returns.

Risk-return profile of Debt Mutual Funds

What are the types of Debt Mutual Funds?

As per SEBI guidelines on categorization and rationalization of schemes, Debt Mutual Funds are categorised as follows:

Overnight Fund	Schemes that invest in overnight securities having maturity of 1 day
Liquid Fund	Schemes that invest in debt and money market securities with maturity of up to 91 days only
Ultra Short Duration Fund	Schemes that invest in debt & money market instruments with Macaulay duration of the portfolio between 3 months - 6 months
Low Duration Fund	Schemes that invest in debt & money market instruments with Macaulay duration portfolio between 6 months - 12 months
Money Market Fund	Schemes that invest in money market instruments having maturity up to 1 Year
Short Duration Fund	Schemes that invest in debt & money market instruments with Macaulay duration of the portfolio between 1 year - 3 years
Medium Duration Fund	Schemes that invest in debt & money market instruments with Macaulay duration of portfolio between 3 years - 4 years
Medium to Long Duration Fund	Schemes that invest in debt & money market instruments with Macaulay duration of the portfolio between 4 - 7 years
Long Duration Fund	Schemes that invest in debt & money market Instruments with Macaulay duration of the portfolio greater than 7 years
Dynamic Bond	Schemes that invest dynamically across duration
Corporate Bond Fund	Schemes that invest a minimum of 80% of their assets in corporate bonds rated AA+ and above
Credit Risk Fund	Schemes that invest a minimum of 65% of their assets in corporate bonds rated AA and below
Banking and PSU Fund	Schemes that invest a minimum of 80% of their assets in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions, and Municipal Bonds
Gilt Fund	Schemes that invest a minimum of 80% of their assets in G-secs, across maturity
Gilt Fund with 10-year constant Duration	Schemes that invest a minimum of 80% of their assets in G-secs, such that the Macaulay duration of the portfolio is equal to 10 years
Floater Fund	Schemes that invest a minimum of 65% of their assets in floating rate instruments (including fixed rate instruments converted to floating rate exposures using swaps/ derivatives)

Source: AMFI

What are the key benefits of investing in Debt Mutual Funds?

• A medium for diversifying your mutual fund portfolio
• Managed by professional fund management possessing respectable qualifications and years of experience
• The cost of investing is low (with a low expense ratio compared to equity funds)
• You could choose to invest in Direct Plan or Regular Plan, choose the Growth or IDCW option, plus make lump sum and/or SIP investments
• Offers liquidity: depending on the type of debt fund, the money can be withdrawn subject to an exit load, if any
• Could potentially offer better returns than a savings bank account and bank FD

Fixed Deposits vs Debt Mutual Funds: Which is better?

Fixed Deposits (FDs) are a suitable investment option for those looking for guaranteed returns over the short to medium term with little or no risk. But, for investors willing to take low to moderate risk, investment in debt mutual funds can potentially generate higher returns than fixed deposits, especially during a falling interest rate scenario. Moreover, debt mutual funds are an excellent option to diversify the portfolio with low-risk investment avenues that have high liquidity.

What are the tax implications of investing in Debt Mutual Funds?

After the passage of the Finance Bill 2023, Debt Mutual Funds are now at par with bank fixed deposits in terms of taxation. The realised capital gains made on Debt Mutual Funds, whether short-term (less than 36 months) or long-term (36 months or more), are now taxed as per the tax slab applicable to an individual investor.

The indexation benefit that earlier helped to make the most of the inflation impact on the purchase value of the investment and effectively reduced the LTCG tax liability is now no longer available for Debt Mutual Funds. Watch the video below to know about this in detail.

Does it make sense to start SIP in Debt Mutual Funds or a lump sum?

A systematic Investment Plan (SIP) makes sense only if the investment time horizon is longer and depends on the sub-category of the Debt Mutual Fund one chooses to invest in. However, by and large, do note that the SIP returns in debt funds could be muted (in contrast to equity mutual funds). In other words, the rupee-cost advantage does not necessarily work to investor's best advantage in case the NAV of the Debt Mutual Fund does not move up or down much.

Typically, enrolling for SIPs in Credit Risk Funds, Medium to Long Duration Debt Funds, Long Duration Funds, Gilt Funds, and Dynamic Bonds, where the volatility in their NAV movement could be on the higher side (due to their inherent traits and portfolio characteristics), could make sense. But for shorter-maturity funds like Overnight Funds, Liquid Funds, Ultra Short Duration Funds, and Money Market Funds, SIPs would not make sense.

How to select the best Debt Mutual Funds for investment?

Although debt mutual funds are relatively less risky than equity mutual funds, they aren't risk-free. There have been instances in the past where even the safest categories have incurred heavy losses due to exposure to low-credit quality papers.

Thus, as an investor, it is important to consider only the best debt mutual funds that give preference to safety over chasing returns by investing in risky debt instruments. Opt for debt mutual fund schemes that hold high-quality papers, such as those issued by the government or quasi-government entities.

It is also important to understand that it would be prudent to avoid selecting the best debt mutual funds based solely on their past performance. The sub-categories and schemes that performed well in the past may not necessarily do well in the future. Instead, investors should pay attention to their risk profile and time horizon when investing in debt funds which will help to mitigate the impact of interest rate risk and credit risk.

Thereafter, to make the best choice among the plethora of schemes available within the respective sub-categories of debt funds, evaluate a host of quantitative and qualitative parameters such as the following:

• The credentials and experience of the fund management team
• The portfolio characteristics (who are the issuers, the sector they belong to, the type of debt papers held, the ratings of the respective debt papers, etc.)
• The maturity profile of the fund
• Returns across time periods (3 months, 6 months, 1 year, 2 years, 3 years, and so on)
• The risk ratios (Standard Deviation, Sharpe Ratio, Sortino Ratio, etc.)
• The current interest rate cycle
• The performance across interest rate cycles

Which are the best Debt Mutual Fund sub-categories to invest in the current interest rate cycle?

The RBI has hiked interest rates by 250 bps cumulatively since mid-2022 to tame elevated inflationary pressure. However, the RBI has paused interest rates in the last two policy meetings as the central bank is of the view that the rate hike undertaken is transmitting through the economy and its fuller impact should keep inflationary pressures contained in the coming months.

The RBI has chosen to remain focused on the withdrawal of accommodative stance to ensure that inflation progressively aligns with the target while supporting growth. Given that inflation has cooled off from its peak, it appears that we are near the end of the interest rate upcycle. Thus, it would be an opportune time now to invest in medium to long-term debt mutual funds whereby you benefit from higher yield and unlock the capital growth.

Investors who are willing to assume slightly higher risk and have an investment horizon of at least 2-3 years, can consider Medium to Long Duration Debt Funds, Long Duration Funds, Gilt Funds, and Dynamic Bond Funds in the current interest rate cycle.

For those who can't afford to take slightly higher risk and/or the investment horizon is very short-to-short (a few days, weeks or a few months), Overnight Funds, Liquid Funds, Ultra Short Duration Funds, and/or Money Market Funds could be considered.

Which are the best Debt Mutual Funds to invest in 2023?

Click here to find out PersonalFN's list of the 5 best Debt Mutual Funds to Invest in 2023.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision.

This article first appeared on PersonalFN here.