Debt mutual funds invest in bonds, debentures and money market instruments. The securities trade in the debt market and money market, at either discount or premium to its face value (par value) depending on the residual maturity of the security and interest rate environment. Interest rate is the most significant risk factor in fixed income securities and debt mutual funds.
Price of bonds (and other fixed income securities) has an inverse relationship with interest rates. If interest rates go up, bond prices decrease and vice versa. In a declining interest rate environment bonds (and debt mutual funds) give higher returns, while in a rising interest environment bonds (and debt mutual funds) give lower returns. However, the impact of interest rate changes on price is for bonds of different maturities.
Price sensitivity of a bond to interest rate changes is directly related to the maturity of the bond. Long maturity bonds are most sensitive to interest rate changes, while short maturity bonds are less sensitive. Money market instruments which have very short maturity profiles are the least sensitive to interest rates.
Different categories of debt mutual funds invest in bonds (and other fixed income securities) of different maturity profiles. Medium and long duration debt mutual funds invest in bonds of moderate to long maturities; as a result the interest rate risk of these types of debt mutual funds is high. Short duration debt mutual funds invest in short maturity bonds and the interest rate risk of these funds is relatively less. Money market mutual funds like overnight funds, liquid funds, ultra-short duration funds etc. invest in very short duration (less than 1 year) money market instruments; interest rate risk is lowest in these types of debt mutual funds.
Investors should choose debt mutual funds based on their risk appetite and investment objectives (income, capital appreciation etc.).
Did you know about Risk factors in debt mutual funds – Credit Risk
