Types of debt funds and how to diversify your portfolio with debt funds

Diversification is a fundamental strategy in investment management. It aims to spread risk across different asset classes. In this context, debt funds play a crucial role in diversifying portfolios, offering relative stability and potential for income generation.

Through this article, we aim to explain the nuances of debt funds and their integration into a portfolio to achieve a balanced and diversified investment approach.

• Table of contents

1. What are debt funds?
2. Types of debt funds
3. Benefits of debt funds
4. How to diversify portfolio with debt funds?
5. FAQ

What are debt funds?

Debt funds are mutual funds that predominantly invest in fixed-income securities such as government bonds, corporate bonds, treasury bills, and other debt instruments. These funds aim to generate potentially steady income for investors. Debt funds are managed by professional fund managers who allocate investments across various debt securities based on the objectives of the mutual fund.

Types of debt funds

Liquid funds – These funds invest in short-term debt instruments with a maturity period of up to 91 days, offering high liquidity and relative stability.

Short-term funds – Investing in debt securities with a slightly longer maturity period than liquid funds (typically up to 1-3 years), these funds aim to provide a relatively better return potential compared with funds like liquid or overnight funds.

Ultra short duration funds – These funds invest in debt instruments with a slightly longer duration than liquid funds, typically ranging from 3 months to 6 months. They aim to provide slightly higher returns while maintaining liquidity.

Income funds – Income funds invest across a range of debt instruments, including government securities and corporate bonds, with the objective of generating regular income for investors.

Gilt funds – Gilt funds predominantly invest in government securities or bonds issued by the central or state governments. They offer relatively lower risk due to the sovereign guarantee but are sensitive to interest rate changes.

Dynamic bond funds – These funds have the flexibility to alter their portfolio duration based on changing interest rate scenarios. They aim to capitalise on interest rate movements to optimise the return potential.

Corporate bond funds – Investing primarily in high-rated corporate bonds, these funds offer relatively higher returns than government securities while maintaining a certain level of relatively stability by investing in high rated instruments.

Fixed maturity plans (FMPs): FMPs have a fixed investment horizon and invest in debt instruments with maturities aligned with the scheme's tenure, seeking to provide relatively stable returns.

Benefits of debt funds

Stability: Debt funds seek to offer relative stability and lower volatility compared to equity investments, making them suitable for conservative investors seeking steady returns.

Regular inflow of funds:Certain debt funds, like income funds, aim to provide a regular income stream through interest payments generated from the underlying debt instruments.

Diversification: Including debt funds in a portfolio provides diversification, reducing overall risk by balancing the impact of market fluctuations experienced in equity investments

How to diversify portfolio with debt funds?

Assess risk tolerance and investment goals: Determine your risk tolerance and investment horizon to identify the proportion of debt funds suitable for your portfolio.

Selecting the right debt funds: Choose debt funds aligned with your investment goals. Consider factors such as fund type, credit quality of underlying securities, expense ratio, and historical mutual fund performance.

Allocation strategy: Decide on the allocation percentage for debt funds in your portfolio based on your risk profile. A more conservative investor might allocate a higher percentage to debt funds for relative stability.

Periodic review and rebalancing: Regularly review your portfolio's asset allocation and rebalance if necessary to maintain the desired mix of equity and debt funds.

Diversification across debt categories: Consider diversifying within debt funds by investing across different categories like liquid funds, short-term funds, and gilt funds to spread risk.

Conclusion

Integrating debt funds into an investment portfolio offers relative stability, income generation potential, and risk mitigation. By diversifying across various types of debt funds, investors can achieve a balanced portfolio that aims to withstand market fluctuations and aligns with their investment objectives.

FAQs:

Are debt funds entirely risk-free?
While debt funds are relatively less risky than equities, they are subject to credit risk, interest rate risk, and market fluctuations. Choosing the right type of debt fund can mitigate these risks to some extent.

Can debt funds provide higher returns compared to other investments?
Debt funds generally offer relatively stable but moderate returns compared to equities. The potential returns depend on the type of debt fund and prevailing market conditions.

Is it advisable to invest in debt funds for short-term goals?
Yes, debt funds can be suitable for short-term goals due to their relatively lower volatility and stability, especially liquid and short-term funds.

How frequently should one review their debt fund investments?
It's advisable to review your debt fund investments periodically, preferably once every six months or as per changes in your financial circumstances or investment goals.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.