What are the different types of debt funds?

Debt funds are complex investment options. Complex, not because they’re difficult to understand, but because they invest in a mix of assets. And naturally, when there’s a mix, there are multiple possible combinations, right? This paves way for different types of debt funds.

It’s interesting to get to know these types, because based on different parameters like their core investments, the period of holding, and the nature of interest, they are suitable for different investor profiles. 

At the outset, debt funds may generally be a good investment choice for you if you are a conservative investor. However, within the classifications given, some debt funds may be more suitable for you than others. In fact, there are as many as 11 different types of debt mutual funds. So, without any further delay, let’s get right into the thick of things.

Types of debt funds

Here’s an in depth look at the different types of debt mutual funds.

• Liquid funds:

As the name suggests, liquid funds invest in debt instruments that are highly liquid in nature. Generally, liquid funds have a short maturity period of up to 91 days. In addition to being liquid, these funds are also relatively much safer with very low amounts of risk. Collateralized Lending & Borrowing Obligations (CBLOs), Certificates of Deposit (CD), Treasury Bills (T-bills), and Commercial Paper (CP) are some of the instruments that these funds invest in. We’ll get into the details of liquid funds in the next chapter.

What is its identifying feature? 

Maturity period of less than 91 days

Who is it suitable for?

Investors looking for an alternative to savings bank accounts

• Ultra short-term funds:

Ultra-short term funds invest in money market and other debt instruments with a maturity period of less than a year. Although not as low-risk as liquid funds, ultra short-term funds typically carry low risk. And they offer returns that are slightly higher than what liquid funds offer. 

What is its identifying feature?

Maturity period of less than one year 

Who is it suitable for?

Investors looking for an option to invest surplus money

• Short-term funds:

Funds that invest in instruments carrying a maturity period ranging from 1 year to around 3 years are generally termed as short-term funds. That said, most short-term funds mature in just around a year or so. These funds are positioned right between ultra short-term funds and long-term funds. 

What is its identifying feature?

Maturity period ranging from 1 year to 3 years

Who is it suitable for?

Investors looking for an alternative to bank fixed deposits 

• Long-term funds:

Long-term funds tend to usually invest in medium to long duration instruments with maturity periods ranging from 3 years to around 10 years. Such funds do well when there’s a fall in the interest rates in the country. This is because the interest rate and the NAV of the fund are inversely correlated with each other. 

What is its identifying feature?

Maturity period ranging between 3 years and 10 years 

Who is it suitable for?

Perfect for investors with very long investment horizons 

• Fixed Maturity Plans (FMPs): 

Fixed Maturity Plans are basically close-ended debt mutual funds that carry a fixed maturity date. They’re very similar to term deposits. These funds typically invest in instruments with a pre-determined maturity period that’s slightly less than the period of maturity of the fund. Upon maturity, the fund is automatically redeemed at the present NAV and the proceeds are returned to the investors. Although they are close-ended funds, FMPs are listed on the stock exchange and can be sold to meet your liquidity requirements.

What is its identifying feature?

Fixed maturity ranging between 30 days and 60 months

Who is it suitable for? 

Investors looking for an alternative to bank fixed deposits 

• Gilt funds:

The term ‘gilt’ refers to government securities. And as the name implies, these funds invest only in government securities. Since the instruments are all issued by the government, they carry absolutely no risk of default whatsoever. That said, the market value of these funds tends to shift in accordance with the interest rates in the country. 

For instance, if the interest rates fall, the market value of these funds rise up and vice versa. The maturity period of gilt funds is generally very long. They tend to start at around 3 years and go all the way up to 20 years. 

What is its identifying feature? 

Zero risk of default 

Who is it suitable for? 

Investors looking for a safe, long-term investment option

• Monthly Income Plans (MIPs):

Monthly Income Plans are funds that invest in a mix of both equity and debt instruments. These funds typically invest not more than 30% of their funds in equity, with the rest going towards debt securities. As the name indicates, MIPs provide investors with a regular source of income in the form of dividend and interest payouts. That said, there’s no dividend guarantee and the payment of the same is subject to availability of profits. 

What is its identifying feature?

Mix of both equity and debt instruments

Who is it suitable for? 

Perfect for investors looking for a steady source of income

• Capital Protection Oriented Funds (CPFs):

CPFs are specially crafted debt funds that're designed to prevent erosion of investment capital. The focus of these funds is primarily towards protection of capital instead of guaranteed returns or capital appreciation. Being close-ended debt funds, CPFs invest around 80% of their funds in AAA-rated bonds (which are among the bonds with the highest credit ratings), and the remaining funds go towards equity. 

What is its identifying feature?

Offers capital protection

Who is it suitable for? 

Perfect for risk averse investors that prioritize capital protection

• Dynamic bond funds:

Unlike the other debt funds in this list, dynamic bond funds invest in debt securities with widely varying maturity periods. Such funds are actively managed by fund managers who have the freedom and the flexibility to invest in debt instruments that are in line with their interest rate views. In an environment where the interest rates are rising, the fund manager actively invests in debt funds with short maturity periods, and vice versa.  

What is its identifying feature? 

Flexible maturity periods

Who is it suitable for?

Investors looking to minimize interest rate risk 

• Credit opportunity funds:

These funds invest in debt instruments that offer high rates of interest for better returns and yields. However, this comes at a trade-off. Bonds that offer high returns are usually rated far lower than bonds that offer lower returns. This increases the risk of default.    

Why do bonds with higher returns generally come with low credit ratings? Let’s look at a hypothetical scenario.

Take these two securities:

1. A bond issued by a profitable, established, 30-year old company, offering interest at 7% annually
2. A bond issued by another 30-year old company - one that has been making losses periodically - offering interest at 7% annually

Here, which bond would you choose to invest in? We’re guessing option 1, because that company has a better track record than the other one, doesn’t it? But does it mean the company in the second case does not get the funds it needs?

No. It can still get the funds needed, provided it offers up a different incentive - higher returns. So, in option 2, the less profitable company may need to offer interest at say 7.5% or 8% in order to attract investors. On the other hand, a company with a good track record already has a USP, so it does not need to rely on offering higher returns to invite investors.

What is its identifying feature?

Offers high rates of interest

Who is it suitable for?

Investors with an appetite for high risk 

• Floating rate funds:

The main aim of floating rate funds is to invest in securities that offer floating interest rates. The interest rates of these funds are directly linked to the Mumbai Inter-Bank Offer Rate (MIBOR), which is widely considered to be the benchmark for debt securities. The interest rates of these funds are periodically reset to get it in line with the prevailing MIBOR.

What is its identifying feature? 

Flexible interest rates

Who is it suitable for?

Investors looking for stable returns that are in line with the current interest rates

Wrapping up

Whew! We’ve finally come to the end of this chapter. In the next one, we’ll be taking up the first type of debt fund in this list - the liquid fund - and get to know what that is all about.

A quick recap

• Liquid funds invest in debt instruments that are highly liquid in nature. Generally, liquid funds have a short maturity period of up to 91 days. 
• Ultra-short term funds invest in money market and other debt instruments with a maturity period of less than a year. 
• Funds that invest in instruments carrying a maturity period ranging from 1 year to around 3 years are generally termed as short-term funds. 
• Long-term funds tend to usually invest in medium to long duration instruments with maturity periods ranging from 3 years to around 10 years.
• Fixed Maturity Plans are basically close-ended debt mutual funds that carry a fixed maturity date. 
• Gilt funds invest only in government securities.
• Monthly Income Plans (MIPs) provide investors with a regular source of income in the form of dividend and interest payouts. 
• Capital Protection Oriented Funds (CPFs) are specially crafted debt funds that're designed to prevent erosion of investment capital.
• Dynamic bond funds invest in debt securities with widely varying maturity periods.  
• Credit opportunity funds invest in debt instruments that offer high rates of interest for better returns and yields. 
• The main aim of floating rate funds is to invest in securities that offer floating interest rates.