Debt funds are not all the same

Investors often describe their holdings as 'some equity and some debt', as if debt were one thing. It is not. The debt category covers schemes that behave very differently from each other, and the difference comes down to two variables: how long the underlying instruments have to run, and how creditworthy the borrowers are.

Duration: how much a rate change hurts

Bond prices move inversely to interest rates. The longer the average maturity of what a scheme holds, the more its value moves when rates change. A liquid fund holding paper maturing within weeks barely reacts to a rate move; a gilt fund holding long-dated government bonds can move noticeably.

This is why the recommended holding period differs by category. It is not an arbitrary suggestion — it is roughly the period over which the interest earned is expected to absorb the price movement you might see along the way.

Credit: who is actually borrowing

The second variable is the quality of the borrower. Government securities carry sovereign risk. Highly rated corporate paper carries limited credit risk. Lower-rated paper offers a higher yield precisely because the risk of delayed or missed repayment is higher.

A scheme with a visibly higher yield than its peers is almost always taking more credit risk, more duration risk, or both. The yield is not free, and the Scheme Information Document sets out what the scheme is permitted to hold.

Matching the category to the need

Money you may need within weeks belongs in liquid or overnight categories. Money with a one to three year horizon suits low duration, short duration or corporate bond categories. Money that can sit for longer, and can tolerate interim movement, can consider longer duration categories.

Debt schemes are not deposits. They do not carry an assured rate of return, the value can fall, and there is no capital protection. What they offer instead is liquidity and, in the appropriate category, a smoother ride than equity.

Where debt actually earns its place

For most portfolios, debt is not the growth engine. It is the part that is available when something goes wrong, the part that does not need to be sold at a bad price, and the part that makes it psychologically possible to leave the equity alone.

That is a real function, and it is the reason the debt allocation usually matters more in a bad year than in a good one.