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Business News/ Mutual Funds / How to choose the right debt mutual fund? Types, risks and rewards explained
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How to choose the right debt mutual fund? Types, risks and rewards explained

Debt mutual funds are like big piggy banks where investors lend money to earn returns. Different types include overnight, liquid, low duration, and more, catering to various risk preferences and investment goals.

When you put your money into a debt mutual fund, you effectively gain ownership of a portion of all the bonds or loans held by the fund.Premium
When you put your money into a debt mutual fund, you effectively gain ownership of a portion of all the bonds or loans held by the fund.

Imagine you have a piggy bank. When you put your money in the piggy bank, you expect to get it back later, right? Now, think of a debt mutual fund like a big piggy bank where lots of people put their money together. These piggy banks, or debt mutual funds, don't just keep the money safe, they also lend it out to others, like banks or companies, who promise to give the money back later with a little extra as a thank you, like how you might get a little extra candy when you lend your toys to a friend.

So, when you invest in a debt mutual fund, you're basically letting a big piggy bank borrow your money for a while, and in return, they give you a little extra back when you need it, just like how you get a little extra candy when you share your toys!

When you invest in a debt mutual fund, you essentially become a part-owner of all the bonds or loans that the fund has invested in. The returns you receive from a debt mutual fund typically come from the interest payments made on these bonds or loans, as well as any capital gains if the value of the bonds increases.

How do debt mutual funds work? 

Imagine you have a big jar, and you ask your friends to put some money into it. Now, instead of keeping that money in the jar, you decide to lend it out to others who need it, like your friends who want to borrow some toys. Debt mutual funds work in a similar way. Lots of people put their money into a big pot called a mutual fund. Then, instead of just sitting there, the mutual fund manager takes that money and lends it out to different borrowers, like companies or governments.

These borrowers promise to pay back the money they borrowed, along with a little extra called interest. That interest is like a "thank you" for letting them borrow the money. When you invest in a debt mutual fund, you're basically lending your money to the mutual fund, which then lends it out to others. In return, you get a share of the interest that the borrowers pay back. It's a way to make your money work for you while helping others who need to borrow it.

Types of debt mutual funds 

Overnight funds - They are a type of mutual fund where the money is invested in very short-term instruments, typically for just one day. They are called "overnight" funds because the investments are made for a very short duration, usually overnight.

Liquid funds - The fund invests the money in short-term debt securities with maturities ranging from 1 week to 91 days only. These funds are designed for investors who prioritise safety and liquidity while seeking modest returns on their investments.

Low duration funds - These funds provide moderate returns with slightly higher risk than ultra short duration funds. They typically invest in debt securities with maturities ranging from 6 months to 1 year.

Ultra short duration funds - These funds invest in debt securities with short maturities, typically ranging from 3 to 6 months. They offer relatively higher returns compared to fixed deposits while maintaining low risk.

Money market funds - They are open-ended investment schemes where capital is invested in money market instruments for a short duration, typically up to a year.

Short duration funds - They invest in short-term instruments such as short-term government bonds, corporate bonds, and debentures. The maturity period for these funds ranges from 1 to 3 years.

Medium duration funds - Like short duration funds, medium duration funds invest in debt instruments. However, the maturity period for medium duration funds typically ranges from 3 to 4 years.

Medium to long duration funds - They invest in debt securities with maturities ranging from 4 to 7 years. These funds carry a slightly higher interest rate risk compared to shorter-duration funds. They tend to perform well when interest rates are falling and may face challenges when interest rates rise.

Long duration funds - They invest in long-term debt instruments with maturities exceeding 7 years. These funds typically carry higher risk compared to other types of debt funds mentioned earlier. However, they generally pose lower risk compared to equity mutual funds.

Corporate bond funds - They invest primarily in bonds issued by corporations which is a minimum 80% investment in corporate bonds only in AA+ and above rated corporate bonds. Unlike other funds categorised by maturity periods, corporate bond funds select investments based on the credit ratings of the securities. These funds are suitable for cautious investors seeking safe and secured debt mutual funds.

Banking and PSU funds - They primarily invest at least 80% of their fund assets in instruments issued by banks, Public Sector Undertakings (PSUs), and public financial institutions (PFIs) and municipal bonds.

Gilt funds - They primarily invest 80% of their fund assets in government securities of varying maturity periods. While the default risk associated with these securities is low, gilt funds carry a higher interest rate risk.

Dynamic funds - These funds invest in debt instruments based on the prevailing interest rate movements in the market. The fund manager adjusts the portfolio according to the changing market conditions.

Floater funds - They allocate a minimum of 65% of their fund assets into floating-rate bonds (including fixed-rate instruments converted to floating-rate exposures using swaps/derivatives). The interest rates of these bonds change in accordance with fluctuations in the market interest rates.

Gilt fund with 10 year constant duration - These funds specifically invest in government securities (gilts) with a targeted constant duration of 10 years.

Credit risk fund - They primarily invest in debt instruments with lower credit ratings or those issued by entities with a higher credit risk profile i.e., minimum 65% investment in corporate bonds, only in AA and below rated corporate bonds. These funds seek to generate higher returns by taking on higher credit risk.

In conclusion, debt mutual funds offer investors opportunities to invest in a variety of fixed-income securities such as government bonds, corporate bonds, and money market instruments. They provide the potential for stable returns, liquidity, and diversification while managing risk through varying durations and credit profiles, catering to different investor preferences and goals.

Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited

 

 

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Published: 28 Feb 2024, 12:47 PM IST
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