A Beginner’s Guide to Debt Mutual Funds: Meaning, Risks & Popular Categories


Debt mutual funds are one of the most misunderstood investment products.
Many investors assume they are “safe” or “just like bank FDs,” but this is far from the truth.
Before investing in debt funds, it is important to understand what debt actually means, what risks it carries, and how different types of debt funds work.

This guide breaks it all down using simple explanations and relatable examples.

What Exactly Is Debt?

Consider a simple scenario:

You want to buy an apartment worth ₹1.5 crore.
You have ₹40 lakh as down payment but still need ₹1.1 crore.

You approach a bank and borrow the remaining amount.
The bank offers you a loan at 8.5% for 10 years, after checking:

  • Your credit score
  • Your repayment capacity
  • The collateral (your apartment)

From the bank’s perspective, this loan is a debt instrument, and the bank earns money through the interest you pay.
But even with collateral, the bank faces the following risks:

Types of Debt Risks

  1. Cash Flow Risk
    You may delay or miss EMIs.

  2. Default Risk
    You may completely stop paying.

  3. Interest Rate Risk
    Market interest rates may change, affecting returns.

  4. Credit Rating Risk
    Your credit score may deteriorate after taking the loan.

  5. Asset Risk
    Property prices may fall, reducing collateral value.

These same risks exist even when companies borrow money.

Debt for Companies: The Bond Market

Suppose a company wants to raise ₹1,000 crore for expansion.

It has two choices:

  1. Borrow from a bank
  2. Raise money from the public by issuing bonds

A bond is simply a loan taken from investors.

Example:
If you invest ₹10 lakh in a company bond offering 8.5% interest, you receive:

  • ₹85,000 interest every year (called coupon payment)
  • ₹10 lakh principal at maturity

But the same risks apply:

  • Credit risk

  • Default risk

  • Interest rate risk

That’s why bonds are not risk-free, even though many investors think so.

Where Do Debt Mutual Funds Fit In?

Asset Management Companies (AMCs) pool money from investors and purchase:

  • Government bonds
  • Corporate bonds
  • Treasury bills
  • Commercial papers
  • Overnight borrowing instruments

A mutual fund holding such assets is called a Debt Mutual Fund.

Debt funds do not invest in stocks.
They invest only in fixed-income instruments.

There are around 16 types of debt mutual funds—as per SEBI’s classification.
Let’s explore the most important ones.

1. Liquid Funds

Liquid funds are one of the most popular debt fund categories.

SEBI’s Definition

Liquid funds may invest only in debt securities with a maturity of up to 91 days.

Example of Instruments Held

  • Commercial Papers (CPs) issued by companies
  • Treasury Bills (T-Bills) issued by the government

Who Should Invest?

People who want to:

✔ Park extra money temporarily
✔ Have high liquidity
✔ Avoid locking funds

Investors typically use liquid funds for money they will need within a few months to a year.

But Are Liquid Funds 100% Safe?

No. They carry credit risk.

Example:
In February 2017, Taurus Mutual Fund’s liquid scheme had invested in commercial papers of Balarpur Industries, which later defaulted.
Investors lost money.

Such incidents are rare but possible.

2. Overnight Funds

Overnight funds invest only in overnight securities—instruments that mature in just 1 day.

They are considered one of the safest debt fund categories because:

  • Maturity is only 24 hours
  • Default risk is extremely low
  • Funds are re-invested daily

Who Should Invest?

✔ People looking to park very short-term surplus
✔ Corporates with daily liquidity needs
✔ Investors prioritizing capital protection over return

Returns are low, but the risk is also minimal.

Debt Funds Are NOT Risk-Free

Many investors treat debt funds as an alternative to bank FDs.
But debt funds:

  • Can face defaults
  • Can lose principal
  • Are affected by interest rate movements
  • Depend heavily on the credit quality of bonds

Understand the risks before investing.

Key Takeaways

  • Debt means borrowing—whether by individuals, companies, or governments.
  • Debt instruments carry risks like default, interest rate, cash flow, and credit rating risks.
  • Debt mutual funds invest in bonds, treasury bills, commercial papers, and money market instruments.
  • Liquid Funds → invest in 91-day maturity instruments
  • Overnight Funds → invest in 1-day maturity instruments
  • Neither liquid nor overnight funds are completely risk-free (though overnight funds are the safest category).
  • Debt funds are ideal for capital protection, short-term goals, and parking surplus funds, not for high returns.


Krishicode

Posted by Krishicode