Understanding Debt Mutual Funds — Part 2

In the previous article we looked at type of debt instruments and maturity/duration based debt mutual fund categories. In this article, we will elaborate on theme based debt mutual fund categories. SEBI has defined these categories based on the kind of instruments the mutual fund invests in, for example, corporate bonds, Government bonds, etc. SEBI has also put limits on how much risky instruments the fund can carry, which is typically measured through credit ratings of the instruments held.

So let’s understand what are credit ratings. These are ratings issued by credit rating agencies like CRISIL, ICRA, etc. to debt instruments on the basis of the borrower’s creditworthiness. Simply put, these ratings represent the risk of default by the borrower. There are generally two ratings for a borrower: short term and long term.

Short term debt ratings are assigned to instruments with an original maturity period of up to one year. These ratings range from A1+ to D, where A1+ stands for the highest rating (least risk of default) and D stands for default/expected-to-default rating. Similarly, long term debt ratings are assigned to instruments with original maturity above one year. These ratings range from AAA to D, where AAA stands for the highest rating (least risk of default) and D stands for default/expected-to-default rating. As per SEBI, securities with AAA and AA+ ratings are considered to be the highest rated.

Typically, the lower the credit rating of the underlying instruments of a mutual fund, higher is the expected return from the fund due to higher risk of default (credit risk) it carries.

There are six theme-based debt categories according to SEBI’s definition:

1. Corporate Bond Funds: These funds invest at least 80% in corporate bonds having highest credit rating i.e. AAA and AA+
2. Credit Risk Funds: Like the name suggests, these funds invest at least 65% in relatively riskier corporate bonds i.e. having lower credit rating (other than AAA and AA+)
3. Banking & PSU Funds: At least 80% of their funds is invested in debt instruments issued by banks, public sector undertakings and public financial institutions
4. Gilt Funds: This category invests at least 80% in Government Securities having different maturities
5. Gilt Funds with 10 Year constant maturity: As the name suggests, these funds invest at least 80% in Government securities such that Macaulay duration (explained here) of the portfolio is maintained at 10 years
6. Floater Funds: These funds invest at least 65% of the total assets in floating rate debt instruments. Floating rate instruments are debt instruments whose interest rate is not fixed but keeps changing (for example, linked to treasury bills)

If you have read this and the last article, then you will have a hang of the various debt categories by now. Hence the next obvious thought in your mind would be “How to choose a fund most relevant for you?” In our upcoming article we will help you with the same and explain this in a step by step process.