What is Debt?
Let us first understand Debt. Individuals and Institutions raise debt when they need money, and pay interest based on the interest rate and duration of the debt. The interest rates can fluctuate based on the economic scenario. Two most important factors in this transaction are
- The credibility of individual or institution who has raised debt
- The time and duration of the debt is raised
Examples of debt: Fixed deposits by Banks, Debt raised by government, Fixed deposits by companies
Debt Mutual Funds
Debt funds are mutual funds investing in such debt instruments. They are of different kinds depending on the kind of debt instruments they invest in.
Higher the credit rating of the debtor, lesser the chance of default and hence lesser the risk is – however, returns for such instruments can be lower. Lower the duration of the debt, lesser the probability of interest rate fluctuation and hence lesser the uncertainty of returns. It is very important to understand these two factors for debt funds:
- What is the average credit quality of the portfolio
- What is the average maturity of the portfolio
Types of Debt Funds
Debt funds can be classified based on debt securities they invest in. We can consider follows ways.
Classification based on debt issuer
- Gilt Funds invest in government securities and treasury bill and hence carry no risk of default
- Corporate Bond Funds invest in debt securities issued by companies and hence carry certain credit risk (sometimes extra returns provided compensates this risk)
Classification based on tenure of the fund
- Liquid Funds, sometimes also called money market funds invest in short term debt securities up to 91 days maturity. These carry the lowest risk with the highest liquidity
- Ultra Short Term Debt Funds invest in securities with short tenures (less than one year) and carry slightly higher risk than liquid funds. Sometimes these funds are also called Cash or Treasury Management Funds
- Short Term Debt Funds invest predominantly in debt securities with a maturity of upto 3 years.
- Long Term Funds like Gilt Funds and Income Funds invest in long term securities issued by government or corporates. These funds can see greater volatility in returns based on the value of the securities.
Classification based on investment strategy
- Diversified Debt Funds / Income Funds invest in a mix of government and non-government debt securities such as corporate bonds, debentures and commercial paper.
- Dynamic Debt Funds are flexible in terms of the type of debt securities they invest in and their tenures.
- Flexible Maturity Plans, as the name suggests, where investment portfolio is closely aligned to the maturity of the scheme, They are closed-ended funds.
Junk bond schemes invest in securities that have a lower credit rating indicating poor credit quality.