There are different types of debt funds, and each has its own risk profile. Investors invest in them without understanding the risk associated with them and land into trouble later on. It is very important to understand in and every aspect of risks involved with any money market products you invest in to.
People consider debt funds as a better alternative to fixed deposits but not every debt fund is safe as an FD. Like just recently we saw Franklin closing 6 of its debt schemes, BOI AXA fund value getting downgraded to more than 50%. We already warned about these debt funds in our YouTube video 5 months before. After seeing the huge value erosion you can understand that debt fund can be even riskier than an equity fund.
When it comes to debt funds, there is one basic principle. Higher the time frame higher the risk. Shorter the time frame lower the risk and higher the risk, higher can be the returns.
Lets learn about all the credit risk funds and understand their features and risks. It will help you understand which tool is the right one just for your needs and capacity.
#1. Overnight funds
These are the safest fund in the debt fund category. They invest in the overnight asset or in the securities with a maturity period of one day. Investors who want to invest for a very short period of up to a month can invest in such kind of funds.
#2. Gilt fund
Gilt fund invests in government securities only and has no risk of default. Government borrowing usually happens at a lower interest of rate, that’s why these funds won’t delivery great returns but are extremely safe.
#3. Liquid funds
The liquid fund invest in short term assets like treasury bills, government securities, certificates of deposits and call money. Liquid funds are allowed to invest in listed securities only and they can have a maximum exposure of 20% in any particular security. The maximum maturity period of their investment is 91 days. There is an exit load if the investor redeems the fund before a week. Investors with a time horizon of up to 6 months can invest in a liquid fund.
This is also a great category to park your money during uncertainties and still have the power to liquidating your investing in just a day. Since the market has fallen over 40% due to COVID-19, instead of keeping the money in bank, we park our money in Liquid Fund to keep generating steading income and when the time is right to invest all out, we can redeem and invest right away, without losing any capital.
#4. Short term funds
These are debt fund that lends to companies for a period ranging from a one year to three years. They invest in high-quality companies with AAA rating. Investors with a time horizon of up to 3 years can invest in such funds.
#5. Coorporate bond fund
Corporate bond funds invest up to 80% of their assets in bonds of private companies with the highest possible credit rating. Investors with a time horizon of 3 years can prefer such funds.
#6. Banking & PSU funds
In this category, the fund invests in the debt instruments of banks and government companies only. Since the government companies are of high quality and have govt backing, these funds have a very low risk of default. Investors with up to 3 years period can invest in such funds.
#7. Dynamic bond funds
In this kind of fund, the manager invests in the short term or long term debt instruments based on his assessment. If he feels interest rates can go up in future he will reduce exposure to long term debts and if he feels interest rate might go down in future he will increase exposure to long term debt.
These kinds of funds can give higher returns, but if the manager goes wrong in his assessment there can be marked to market loss. Investors with at least 3 years of investment holding period should invest in such kinds of funds.
#8. Credit risk fund
These funds are of high-risk high return nature. They invest 65% of their money below high rating debt. Although they lend usually for a short duration, still they are the riskiest in the debt funds category. Invest in such funds only if you can hold for 3-5 years.
Invest in these funds only if you have thick skin towards any kind of falls or recession and are not afraid of them.
From what we just read, we can conclude the following:
Low-risk funds are gilt fund, overnight fund, and liquid fund, with low return on investment.
Moderate risk funds are Short term funds, Banking and PSU funds, Corporate bond fund, with medium return on investment.
Higher risk funds are Dynamic bond fund, Credit risk fund with variable returns on investment.
Always invest in mutual funds with detailed research of its risk profile, the manager and its past 10 year performance (including its performance during big recessions). Never invest in mutual funds just because it was ranked #1 or #2 in certain category for a couple of years. Never invest in a mutual fund just because a famous investor recommended it.
For example, HDFC Liquid Fund has the highest AUM, but doesn’t give the best returns.
If you have any questions, don’t forget to ask us in the comment section below.
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Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.