Debt Mutual Fund Categories Explained For Retail Investors

Debt mutual fund categories are explained in simple language. Retail investors can use them to understand when to use which category. This is part three of a three-part series by SEBI RIA Swapnil Kendhe

Published: December 8, 2019 at 10:00 am

Understanding which debt mutual fund to use when will take away a lot of confusion associated them for retail investors. Here is a simple explanation of the essential aspects of each debt fund category. This is the next natural step after having covered the basics (part 1), essential portfolio measures (part 2).

If you are new to bonds and how mutual funds holding bonds operate, please start with the first part of this article, Basics of Debt Mutual Funds Explained for New Investors and then come back here. Part two is available here: Three Key Mutual Fund Terms All Retail Investors Should Know.

 About the author: Swapnil Kendhe is a SEBI Registered Investment Advisor and part of my list of fee-only financial planners. You can learn more about him and his service via his website Vivektaru. In the recently conducted survey of readers working with fee-only advisers, Swapnil has received excellent feedback from clients: Are clients happy with fee-only financial advisors: Survey Results.  As a regular contributor here, he is a familiar name to regular readers. His approach to risk and returns are similar to mine, and I love the fact that he continually pushes himself to become better as you see from his articles.

Past articles by Swapnil:


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List of Debt Mutual Fund Categories

It is important that investors understand different categories of debt mutual funds and the risks associated with them. Risks in debt mutual funds can be reduced by selecting the right category of debt mutual funds.

Overnight Fund

Overnight Funds invest in overnight securities having a maturity of 1 business day.

Credit Risk: Credit risk in overnight funds is one of the lowest in debt mutual funds. Typically, banks and deposit-taking financial institutions borrow in the overnight markets to manage their liquidity needs over the course of the day.
Interest rate sensitivity: The modified duration of Overnight Funds is 0 and therefore, there is no interest rate sensitivity in overnight funds.

Yield: Yield of Overnight Funds is the lowest in debt mutual funds.

Exit load: Nil.

When to invest: Investors can park any amount they may need within 3 months in overnight funds.

Liquid Fund

Liquid Funds invest in debt and money market securities with residual maturity up to 91 days.

Credit risk: Liquid Funds are supposed to invest in the most liquid debt securities having residual maturity of up to 91 days. Since the highest credit quality, short-term debt instruments are also the most liquid, true to label Liquid Funds run high credit quality portfolios and are safe. Investors should avoid Liquid Funds that reach for the yield.

Interest rate sensitivity: Modified duration of Liquid Funds is small (less than 0.2 years), therefore, the impact of interest rate changes on the NAV of the fund is negligible.

Yield: Since Liquid Funds hold highest credit quality debt instruments and the maturity duration of the portfolio is the lowest after overnight funds, yield to maturity of liquid funds is one of the lowest in debt mutual funds.

Exit load: Liquid Funds have a tiny exit load up to 7 days.

When to invest: Investors can use liquid Funds for short term and recurring goals. If the size of the portfolio is not big and EPF, PPF and SSY can take care of debt part of the long term portfolio, investors need not use any other debt fund category apart from Liquid Fund.

Whenever in doubt, keep money in Liquid Funds.

Ultra Short Duration Fund and Low Duration Fund

Ultra Short Duration Funds invest in debt and money market instruments such that Macaulay duration of the portfolio is between 3 months and 6 months.

While Low Duration Funds invest in debt and money market instruments such that Macaulay duration of the portfolio is between 6 months and 12 months.

Credit risk: In Ultra Short Duration and Low Duration Funds, fund managers have restriction on the duration of the portfolio, not on the credit quality. Fund managers can run low credit quality portfolios in both these categories to generate a higher yield.

Investors must, therefore, check what credit quality portfolios different fund houses run in their Ultra Short Duration and Low Duration Funds. Investors should prefer funds that keep most of the portfolio in highest rated debt instruments though the yield of such funds is lower than other funds.

Interest rate sensitivity: Since the modified duration of Ultra Short Duration Funds is less than 0.5 and that of Low Duration Funds is less than 1, the impact of interest rate changes on the NAV of these funds is low. Interest rate sensitivity of Ultra Short Duration Funds is lower than Low Duration Funds.

Yield: Yields of these funds are higher than Liquid Funds because of higher duration and lower credit quality portfolios.

Exit load: Nil in Ultra Short Duration Funds. In Low Duration Funds, funds that run good credit quality portfolios do not have an exit load, but funds that run lower credit quality portfolios can have exit load up to 90 days.

When to invest: Investors can use Ultra Short Duration Funds and Low Duration Funds for short term and recurring goals. But they must understand that credit risk in Ultra Short Duration and Low Duration Funds could be significantly higher than Liquid Funds.

Investors should take care that they select funds that run high credit quality portfolios and have relatively lower expense ratio within the category.

Money Market Fund

Money Market Funds invest in money market instruments having maturity up to 1 year.

Money market instruments include commercial papers (short-term unsecured promissory notes issued by companies), certificate of deposit (certificates issued by banks to entities depositing money for a specified length of time at a specified rate of interest), treasury bills (short term debt instruments issued by RBI and government), commercial bills, government securities having unexpired maturity up to one year and other like instruments as specified by the Reserve Bank of India from time to time.

Credit risk: Money Market Funds typically hold highest credit quality short term debt instruments i.e. A1+ rated papers (there is no such restriction on the fund manager). Therefore, credit risk is low in Money Market Funds.

Interest rate sensitivity: Modified duration of Money Market Funds is less than 1 year, therefore the impact of interest rate changes on the NAV of the fund is low.

Yield: Yield of Money Market Funds is slightly higher than Liquid Funds because of higher duration.

Exit load: Nil.

When to invest: Investors can use money market funds for short term and recurring goals. But they should take care that they select funds that run high credit quality portfolios and have relatively lower expense ratio within the category.

Short Duration Fund & Medium Duration Funds

Short Duration Funds invest in debt and money market instruments such that Macaulay duration of the portfolio is between 1 year and 3 years.

While Medium Duration Funds invest in debt and money market instruments such that Macaulay duration of the portfolio is between 3 years and 4 years.

Credit risk: Just like Ultra Short Duration and Low Duration Funds, in both these categories, fund managers have restriction on the average maturity of the portfolio but not on the credit quality.

Investors should be careful in choosing funds in these categories for fund managers can run low credit quality portfolios to increase the yield.

Interest rate sensitivity: Both these categories of funds have higher modified duration compared to Liquid Funds, Money Market Funds, Ultra Short Duration Funds and Low Duration Funds, therefore interest rate sensitivity is higher.

When interest rates go up, these funds lose some value. However, if investors wait for up to 3 years, and if there are no further increases in interest rates, the notional loss could be made up.

Yield: Yield of these funds is higher than Liquid Funds, Ultra Short Duration and Low Duration Funds for the similar credit quality of the portfolio because of higher duration.

Exit load: Funds that run good credit quality portfolios do not have an exit load. Funds that run lower credit quality portfolios in Short Duration category can have an exit load up to 1 year, while in Medium Duration category such funds can have exit load up to 2 years.

When to invest: Investors can use Short Duration Funds and Medium Duration Funds as debt part of long-term portfolios.

Investors should take care that they select funds that run high credit quality portfolios and have relatively lower expense ratio within the category.

Medium to Long Duration Fund & Long Duration Funds

Medium to Long Duration Funds invests in debt and money market instruments such that Macaulay duration of the portfolio is between 4 years and 7 years.

While Long Duration Funds invest in debt and money market instruments such that Macaulay duration of the portfolio is greater than 7 years.

Credit risk: Funds of both these categories have restrictions on the duration of the portfolio but not on the credit quality.

Investors should be careful in choosing funds in these categories for fund managers can run low credit quality portfolios to increase yield.

Interest rate sensitivity: Interest rate sensitivity of both these categories of funds is high because of high modified duration.

Yield: Yields of these funds are comparable with yields of short-duration and Medium Duration Debt Funds for the similar credit quality of the portfolio.

Exit load: Funds that run good credit quality portfolios can have an exit loads up to 30 days, while funds that run lower credit quality portfolios can have an exit load up to 2 years.

When to invest: Retail investors can avoid both these categories because of high-interest rate sensitivity.

Dynamic Bond Fund

Dynamic Bond Funds invest across duration. To understand more about duration see: Three Key Mutual Fund Terms All Retail Investors Should Know and Why you need to worry about “duration” if your mutual funds invest in bonds

Credit risk: There is no restriction on fund managers regarding credit quality of the portfolio. Fund managers can invest in low credit quality debt instruments to generate a higher yield. Some funds in this category even invest in unrated debt instruments.

Interest rate sensitivity: In Dynamic Bond Funds, fund managers dynamically manage the duration of the portfolio to take advantage of interest rate movements.

If the fund manager anticipates that interest rates may move downward, he increases the Macaulay duration of the portfolio, thereby increasing the modified duration. Likewise, he reduces the modified duration of the portfolio if he anticipates that interest rates could move up to reduce the impact of the interest rate increase on fund’s NAV.

Investors should note that it is difficult for fund managers to consistently and correctly anticipate interest rate movements. There are years when fund managers correctly anticipate interest rate movement. There are also years when they go wrong.

Yield: Yield of Dynamic Bond Funds depends on the credit quality of the portfolio fund managers run.

Exit load: Funds that run good credit quality portfolios do not have an exit load in this category. However, funds that run lower credit quality portfolios can have an exit load.

When to invest: Investors can avoid this category if they do not want unpredictability in their debt mutual fund portfolio.

Banking and PSU Fund

Banking and PSU Debt Funds invest a minimum 80% of total assets in Debt instruments of Banks, Public Sector Undertakings and Public Financial Institutions.

Credit risk: Banking debt instruments are safer because RBI is behind banks to provide liquidity support. PSU debt instruments, on the other hand, are safe because there is an implicit sovereign guarantee, meaning the government will step in if anything goes wrong.

In Banking and PSU Debt Funds, there is no restriction on the credit quality of the portfolio. But since fund manager must invest a minimum 80% of fund’s assets in banking and PSU papers, this category is safer compared to some other categories of debt funds.

Fund managers can use the balance 20% funds’ assets to increase the yield of the portfolio by going down the credit quality. Investors must select funds that run high credit quality portfolios.

Interest rate sensitivity: There is no restriction on the Macaulay duration of the portfolio in this category. Fund managers can adjust the duration of the portfolio based on anticipated changes in the level of interest rates.

The average modified duration of Crisil Banking and PSU Debt Index, which is the benchmark for many schemes in this category is 2.99 years. This implies that if interest rates go up, these funds lose some value. However if investors wait for a few years, and there are no further increases in interest rates, the notional loss could be made up.
Yield: Yield of Banking and PSU Funds is higher than Liquid Funds and Money Market Funds due to higher maturity duration and relatively lower credit quality of the portfolio.

Exit load: Nil.

When to invest: Investors can use Banking and PSU Debt Funds in debt part of their long term portfolios. Select funds that run high credit quality portfolios and have relatively lower expense ratio within the category.

Corporate Bond Fund

In Corporate Bond Funds, minimum 80% of total assets are invested in the highest (AA+ and higher) rated corporate bonds.

Credit risk: There is a restriction in Corporate Bond Funds to keep minimum 80% of total assets in the highest-rated corporate bonds. But fund managers can use balance 20% funds’ assets to increase the yield of the portfolio by going down the credit quality. Investors must select funds that run high credit quality portfolios.

Interest rate sensitivity: There is no restriction on the duration of the portfolio in this category. The fund manager can adjust the duration of the portfolio based on anticipated changes in the level of interest rates.

If interest rates go up, these funds lose some value. However, if investors wait for a few years, and if there are no further increases in interest rates, the notional loss could be made up.

Yield: The yield of Corporate Bond Funds is higher than the yield of Banking and PSU debt funds of similar credit quality.

Exit load: Nil.

When to invest: If investors want higher yield than Banking and PSU debt funds and are ready to take higher risk, they can use corporate bond funds in their long term portfolios. Select funds that run high credit quality portfolios and have relatively lower expense ratio within the category.

Credit Risk Fund

Credit Risk Funds invest a minimum of 65% of total assets in below highest-rated corporate bonds.

Credit risk: Since Credit Risk Funds run the lowest credit quality portfolios in debt mutual funds, the risk of default is highest in this category.

Interest rate sensitivity: Interest rate sensitivity of Credit Risk Funds is similar to that of Short Duration Funds.

Yield: The yield of Credit Risk Funds is the highest in debt mutual funds.

Exit load: There could be exit load up to 3 years in some of the funds in this category.

When to invest: Retail investors should stay away from this category.

Gilt Fund

Gilt Funds invest a minimum of 80% of total assets in government securities across maturity.

Credit risk: Since Gilt Funds invest in government papers, credit risk is lowest in Gilt Funds.

Interest rate sensitivity: The modified duration is dynamically managed in Gilt Funds to take advantage of interest rate movements. If the fund manager anticipates that interest rates may move downward, he will increase the average maturity of the portfolio and thereby modified duration. Likewise, he will reduce the modified duration of the portfolio if he anticipates that interest rates could move up to reduce the impact of the interest rate increase on fund’s NAV.

Investors should note that it is difficult to consistently and correctly anticipate interest rate movements. There are years when fund managers correctly anticipate interest rate movement. There are also years when they go wrong.

Yield: Yields of Gilt Funds are comparable with yields of Short Duration Funds investing in the highest credit quality papers.

Exit load: Nil.

When to invest: Return from Gilt Funds could be as high as 20% in some years. The return could also be negative in a few other years. Investors should avoid this category if they do not want this unpredictability in their debt mutual fund portfolio.

Gilt Fund with Constant Maturity

Gilt Funds with Constant Maturity invest a minimum 80% of total assets in government securities such that the Macaulay duration of the portfolio is equal to 10 years.

Credit risk: Since these funds invest in government papers, credit risk is the lowest.

Interest rate sensitivity: Modified duration of Constant Maturity Gilt Funds is 6 years to 7 years. These are the riskiest debt funds as far as interest rate sensitivity is concerned. Runaway inflation can rip the value of these funds down.

Yield: Yields of these funds are comparable with yields of Short Duration Funds that run the highest credit quality portfolios.

Exit load: Nil

When to invest: Retail investors should avoid this category because of high-interest rate sensitivity.

(If investors want to build a debt mutual fund portfolio with near-zero credit risk, they can combine Gilt Fund with Constant Maturity with Liquid Funds like Quantum Liquid Fund which takes near-zero credit risk to create a portfolio with intermediate average maturity.

Suppose you want the duration of the portfolio at around 3 years, you combine 70% Liquid Fund with 30% Constant Maturity Gilt Fund. A decline in interest rates results in steep appreciation of the NAV of Constant Maturity Gilt Funds. Liquid funds act as a cushion in case interest rates rise up.

This strategy can backfire if short-term interest rates drop and long-term rates rise. At such times, this portfolio suffers a double whammy. The value of Constant Maturity Gilt Fund declines. Simultaneously, the yield on Liquid Fund also declines. Retail investors should avoid such strategies.)

Floater fund

Floater Funds invest a minimum of 65% of total assets in floating rate debt instruments.

Floating rate debt instruments are debt instruments where interest rates are reset periodically based on interest rate changes of the selected benchmark such as SBI MCLR.

Credit risk: In Floater Funds, fund managers do not have restriction on the credit quality of the portfolio. Investors should be careful in choosing funds in this category since fund managers can run low credit quality portfolios to increase yield.

Interest rate sensitivity: Since Floater Funds invest predominantly in floating rate debt instruments where coupon rate goes up when interest rates go up, interest rate sensitivity is low in these funds. Benchmark for most schemes in this category is Crisil Liquid and Crisil Ultra ST Debt. The modified duration of the portfolio is typically less than 1 year.

Yield: Yield is higher than Liquid Funds.

Exit load: Nil.

When to invest: Investors can use Floater Funds for short term and recurring goals. Investors should take care that they choose funds that run good credit quality portfolios and have lower expense ratio within the category.

Why Retail investors should prefer the debt funds of bigger fund houses

  • Debt funds of bigger fund houses are likely to be handled by more experienced and competent fund managers. If the fund manager leaves the job, his place is likely to be taken by an equally competent fund manager in bigger fund houses.
  • Smaller fund houses lack the distribution network of bigger fund houses. Therefore, they must generate a higher return in their debt schemes to attract AUM. The only way to generate higher return within a debt fund category is by reducing the credit quality of the portfolio.

There is always the risk of default in debt mutual fund portfolios. Bigger fund houses are better equipped to handle situations of default compared to smaller fund houses.

Catch up on parts 1 and 2 of this series
1: Basics of Debt Mutual Funds Explained for New Investors
2: Three Key Mutual Fund Terms All Retail Investors Should Know

If you wish to work with Swapnil, his website is Vivektaru.

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