Debt Fund: Types, Benefits, and Risk VS Return

Based on the ‘investment objective’, the mutual fund schemes can be broadly classified as either Equity Funds or Debt Funds. This classification is based on the asset allocation of the fund’s investments.

While equity mutual funds invest in shares of publicly listed companies, debt funds invest in fixed income securities issued by the government and companies. These fixed income securities include corporate bonds, government securities, treasury bills, money market instruments and other such debt securities.

Debt funds invest in such fixed income securities, and just like equity funds, they try to optimise returns by diversifying across different types of securities. This allows debt funds to earn decent returns, but there is no guarantee of returns. However, debt fund returns can be expected in a predictable range, which makes them safer avenues for conservative investors.

Types:

Debt funds invest in different securities that have different credit ratings. A security’s credit rating signifies the risk associated with the entity that is issuing the security. A higher credit rating means that the entity is more likely to pay interest on the debt security as well as pay back the principal amount upon maturity. This is why debt funds that invest in higher-rated securities will be less volatile than those that invest in low-rated securities.

Another factor that determines the kind of securities that debt funds invest in is the maturity of that security. Different types of debt funds invest in securities that mature after different time periods. The shorter the maturity period, the less volatile the debt security can be expected to be.

Just like equity mutual funds, debt mutual funds also come in various types. The primary differentiating factor between debt funds is the maturity period of the instruments they invest in. Here are the different types of debt funds.

Income funds

Income funds can also take a call on interest rates and invest in debt securities with different maturities, but most often, income funds invest in securities that have long maturities. This makes them more stable than dynamic bond funds. The average maturity of income funds is around 5-6 years.

Short-term and ultra short-term debt funds

These are debt funds that invest in instruments with shorter maturities, which range from around a year to 3 years. Short-term funds are ideal for conservative investors as these funds are not majorly affected by interest rate movements.

Liquid funds

Liquid funds invest in debt instruments with a maturity of not more than 91 days. This makes them almost risk-free. Liquid funds have seen negative returns very rarely. These funds are good alternatives to savings bank accounts as they provide similar liquidity and higher returns. Many mutual fund companies offer instant redemptions on liquid fund investments through special debit cards.

Gilt funds

Gilt funds invest in only government securities. Government securities are high-rated securities and don’t come with a credit risk because the government is not going to default on the loan it takes in the form of debt instruments. This makes gilt funds ideal for risk-averse fixed income investors.

Credit opportunities funds

These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds don’t invest according to the maturities of debt instruments. These funds try to earn higher returns by taking a call on credit risks. These funds try to hold lower-rated bonds that come with higher interest rates. Credit opportunities funds are relatively riskier debt funds.

Fixed maturity plans

Fixed maturity plans (FMP) are closed-end debt funds. These funds also invest in fixed income securities like corporate bonds and government securities, but they come with a lock-in. All FMPs have a fixed horizon for which your money will be locked-in. This horizon can be in months or years. Investments in FMPs can be made only during the initial offer period. An FMP is like a fixed deposit that can deliver superior, tax-efficient returns but do not guarantee returns.

Benefits

Your investments are not affected by equity market volatility

Add stability to your investment portfolio

Freedom to withdraw your money when required

You can aim for better post-tax returns

They are more tax efficient

Risk VS Return

Sharpe, Markowitz and Miller’s 1990 economics prize was for work that underlies modern portfolio theory, of which I’m definitely not a fan. The idea that the risk-vs-return trade-off is quantifiable also derives from that work. Of course, it’s beyond argument that there is a risk vs returns trade-off. People understand that instinctively. This is not even a financial phenomenon. Even in the prehistoric world, while Homo sapiens were evolving, those who took more risks must have been able to hunt more nutritious animals but with a higher chance of injury or death.

However, there are three problems. One, this risk-vs-return trade-off is not quantifiable, no matter what any Nobel awardee might say. Typically, financial-planning advisors or robot-advisory websites try to ask you some questions to try and judge what they call your risk tolerance. Generally, these questions are along the lines of how much of a temporary loss you feel you can tolerate at a certain time. This doesn’t work.

The risk-vs-return idea of portfolio theory is not transferable to human beings. The risk level a human being can tolerate is not a measurable constant. It can, and does, change quite frequently. Your risk tolerance is actually a function of everything else that is going on in your life. If any other part of your life starts looking shaky – it could be your business, your job, yours or a family member’s health, the state of your other assets – then your risk level could increase. And of course, the reverse is also true.

However, this is just the first big problem with this idea. There’s the second, which is that what we call risk is actually variability of returns. An investment with a high variability doesn’t always deliver high returns. Variability means that it can deliver low or negative returns. In fact, a low-risk investment can generate returns that are higher than a high-risk one. That’s part and parcel of risk. The connection between high returns and high risk is probabilistic. The chances are that high returns come with a higher risk but that’s it – it’s a chance, a higher probability, that’s all.

The third problem is even more subtle. An investment that has the chance of a higher return is likely to have the higher risk. However, the reverse is not true. High risk by itself does not mean higher returns. There are plenty of investments that have a high risk but no chance of high returns. So don’t make a mistake about which is the cause and which is the effect. High returns often come with higher risk. High risk may or may not come with high returns.

At the end of the day, as an investor who is putting money into equity-based funds and perhaps even in equity, you must be aware of the sources of risks, your tolerance to them and how the risks can be mitigated. The biggest payoff of handling risk is that you won’t sell off and run away when the markets decline. That alone can severely impact your returns.