Navigating the Duration Curve: Liquid vs. Corporate Bond vs. Dynamic Term Funds

Liquid funds are open-ended debt schemes that invest in only debt and money market securities with a maturity of up to 91 calendar days. As per general market understanding, these instruments include:

• Treasury bills (T-bills)

• Commercial papers

• Certificates of deposit, and

• Government securities having an unexpired maturity up to one year,

Due to a maximum maturity period of only 91 calendar days, liquid funds carry relatively low to moderate risk and lower volatility compared to other debt funds with a higher maturity period. 

Such debt funds are primarily designed to help investors “park surplus cash” for short periods and earn better potential returns than a savings account but with relatively higher risk. Besides, liquid funds are also used for:

• Emergency reserves

• Short-term savings goals, or

• Temporarily holding funds before making a larger investment.

Note that the returns generated by liquid funds are market-linked and may vary depending on interest rates, credit quality of the underlying instruments, and prevailing money market conditions.

As per SEBI guidelines, corporate bond mutual funds must invest at least 80% of their total assets in corporate bonds rated “AA+” and above. For those unaware, credit ratings in India are assigned by registered credit rating agencies such as CRISIL, ICRA, India Ratings & Research (Ind-Ra), and others. 

These ratings assess a company's ability to meet its debt obligations on time and help investors evaluate the credit risk associated with a bond. For more clarity, let’s have a look at the general credit ratings scale:

(Source: CRISIL Credit Ratings Scale)

Note that the “+” (plus) sign in ratings such as “AA+” is known as a “rating modifier”. It provides a distinction within the same rating category. For example, 

• A bond rated “AA+” is potentially considered stronger and lower to the “AAA” category than a bond rated “AA” or “AA-”, even though all three fall within the broader AA rating band. 

• Similarly, ratings may carry a “–” (minus) sign, indicating that the security is at the lower end of that rating category. 

Furthermore, as per general market understanding, bonds rated “AAA to A” are considered “investments with relatively higher repayment capacity. Whereas ratings below BBB- indicate a comparatively higher probability of credit stress or default. 

Investors may realise that a corporate bond mutual fund may aim to generate returns through a combination of interest income and potential capital appreciation from corporate debt securities rated AA+ and above.

So far, you know that liquid funds are allowed to invest only in debt securities with maturities of up to 91 days. Similarly, corporate bond mutual funds must invest at least 80% of their total assets in “AA+ and above-rated” corporate bonds. 

Now, dynamic term fund is a debt mutual fund scheme that does not carry any such restrictions. As per SEBI guidelines, dynamic term funds can invest across different maturities (durations). There is no pre-defined limit on the portfolio's Macaulay duration or restriction on the types of debt securities the fund can invest in.

As per general market understanding, liquid funds are usually designed to park surplus cash, whereas corporate bond funds may generate potential income from corporate bonds rated AA+ and above. 

On the other hand, dynamic term funds “actively” invest in the market as per changing interest rate cycles and market conditions in pursuit of returns. 

Want to understand the differences better? Let’s check out the detailed comparison below:

So, now you know about the three bond mutual fund categories (Liquid Funds, Corporate Bond Funds, and Dynamic Term Funds) and how they differ from one another. If we were to revise, as per SEBI guidelines:

• Liquid funds can invest only in debt and money market securities with maturities of up to 91 calendar days. 

• Corporate bond funds must invest at least 80% of their total assets in AA+ and above-rated corporate bonds. 

• In contrast, dynamic term funds can “actively” invest across different durations based on the fund manager's outlook on interest rates and market conditions.

Need the “right” choice? It depends on your risk appetite, investment horizon, and financial goals. Investors seeking short-term parking of surplus funds may prefer liquid funds, while those looking for regular income from corporate debt may consider corporate bond funds. 

In contrast, dynamic term funds may suit investors with a relatively higher risk appetite and those interested in a more flexible debt investment strategy (which can be “actively repositioned” across different maturities as per changing market conditions). 

1. Which bond mutual fund scheme carries the lowest risk among Liquid Funds, Corporate Bond Funds, and Dynamic Term Funds?

Liquid funds may potentially have a lower comparative risk due to investments in debt and money market instruments with maturities of only up to 91 days. Such a short maturity profile generally makes them less sensitive to interest rate movements and market volatility.

In comparison, corporate bond funds and dynamic term funds may invest in securities with longer maturities, which can make their NAVs more sensitive to changes in interest rates.
 

2. Can I lose money in a debt mutual fund?

Although debt funds are generally less volatile than equity funds, they are not risk-free. Factors such as rising interest rates, credit rating downgrades, or defaults by issuers can impact fund performance. The extent of risk varies depending on the type of debt fund and its underlying investments.
 

3. What is the general approach of the fund manager of a Dynamic Term Fund when the RBI is reducing repo rates?

When the RBI enters a rate-cutting cycle (an expansionary monetary policy phase), bond prices generally rise because newly issued bonds offer lower yields. In such an environment, the fund managers of dynamic term funds may potentially:

• Increase the portfolio's duration and

• Allocate more assets towards longer-maturity bonds.