The range of debt funds

The categorisation of debt funds is simpler than that of equity funds. A debt fund investment, like a bond, is defined by two characteristics - its maturity and its credit rating. Maturity is a straightforward enough concept that you will encounter when learning how debt funds work. The maturity date of a bond is the date on which the principal value of a bond is to be returned to the investor in full.

A change in interest rates could make a particular bond more or less valuable. When interest rates fall, older bonds that are locked into a higher interest rate are worth more. Conversely, when interest rates rise, older bonds that are locked into a lower interest rate are worth less.

If you think about it, this rise or fall in a bond's value has to be proportional to how much time is left for the bond to mature. This makes perfect sense. For example, when interest rates fall, all older, higher-interest bonds gain value, but one which has ten years left until maturity will gain more value than one which has only one year left till maturity. After all, the one with ten years to go till maturity will go on paying a higher interest rate for that much longer.

What matters most here then is residual maturity rather than the total lifetime of the bond. By residual maturity we mean how much time is left until the redemption date of the bond. In this sense, a twenty-year bond that was issued eighteen years ago and a freshly issued two-year bond have the same residual maturity. If these two bonds are otherwise identical, then a change in the interest rate will impact their value equally.

Residual maturity determines the risk and return level of a bond. The less time left for a bond to mature, the more predictable, less risky and possibly less profitable it will be. Longer maturity bonds are the opposite. This then becomes one important way to classify bonds, both from the point of view of fund companies operating them as well as analysts at Value Research evaluating them.

Based on their maturity, debt funds are classified into these categories:

• Overnight Fund: Investment in overnight securities having maturity of 1 day
• Liquid Fund: Investment in Debt and money market securities with maturity of upto 91 days only
• Ultra Short Duration Fund: Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 months - 6 months
• Low Duration Fund: Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 6 months- 12 months
• Money Market Fund: Investment in Money Market instruments having maturity upto 1 year
• Short Duration Fund: Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 1 year - 3 years
• Medium Duration Fund: Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 years - 4 years
• Medium to Long Duration Fund: Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 4 - 7 years
• Long Duration Fund: Investment in Debt & Money Market Instruments such that the Macaulay duration of the portfolio is greater than 7 years
• Dynamic Fund: Investment across duration.

Besides this maturity-based classification, there are a few other types of debt funds where the kind of securities invested in are specified.

Gilt funds: These funds invest a minimum of 80% of total assets in government securities. These securities, which are also called gilts, are bonds issued by the Government of India. Unlike bonds issued by companies, the chance of the government defaulting on its loan obligation is significantly lower.

Gilt Fund with 10-year Constant Duration: Here, a minimum of 80% of total assets in invested in Gsecs such that the Macaulay duration of the portfolio is equal to 10 years

Corporate Bond Funds: Here, a minimum of 80% is invested in corporate bonds (only in highest-rated instruments)

Credit Risk Fund: Here, a minimum of 65% is invested in corporate bonds (investment in below highest rated instruments).

Banking and PSU Funds: These funds have a minimum 80% investment in debt instruments of banks, Public Sector Undertakings, and Public Financial Institutions

Floater Fund: Here, floating rate instruments comprise a minimum of 65% of total assets.

Read the following articles to learn more about debt funds

How debt mutual funds work
Beginners guide to debt fund categories