The ongoing turmoil in debt funds has left investors wondering which debt fund is best for them among the wide variety available. In reality, you don't have to worry about most types of debt funds. These four debt-oriented categories are all that you will ever need.

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For debt-fund investors, alarm signals keep coming. Every few months or so, some company's bonds go underwater and a handful of debt funds more have sudden, sharp drops in their NAVs. In principle, investors should not be surprised because after all, we're constantly reminded that 'mutual funds are subject to market risk'. In practice, we expect debt funds to be low or zero risk.

The solution is not to avoid all debt funds because debt plays a crucial role in any investment portfolio. Sure, you can just switch to bank fixed deposits or RBI bonds or some such thing, but you'll have to suffer lower returns, higher taxation and poorer liquidity.

As always, the real solution is to be realistic and tune your investments to the risk you can tolerate and this article will help you do exactly that.

What we have here is the ultimate keep-it-simple guide to debt-fund investing. Though Indian fund houses offer 16 different kinds of debt funds, at Value Research, we think that you can get by quite well with just four types. Actually, two of these are hybrid funds but they predominantly invest in debt instruments. Hence, we have discussed them in the same space. Pick your favourite based on your financial goals.

Liquid funds for anytime money
Liquid funds are your best bet if you are looking for a short-term parking ground for your money which you may withdraw at any time. They are the debt funds with the least volatile returns. Liquid funds are mandated to invest in debt instruments that mature within 91 days and in practice, many of them invest in 30- to 60-day securities.

The typical liquid fund's portfolio is made up of treasury bills, commercial paper and CBLO or money-market instruments (instruments through which banks, institutions or companies borrow quick money against collateral).

Therefore, if you've received a big bonus from your employer or a windfall from a rich uncle and are unsure where to invest that money, your immediate parking ground can be a liquid fund until you decide what to do with it. Liquid funds are also ideal for creating that emergency fund amounting to six months or one year of expenses that most financial planners advise. When life hands you googlies such as sudden loss of employment or unexpected illness, money parked in a liquid fund can bail you out.

Liquid funds tend to be the least volatile category of debt funds because they invest in very short-term debt instruments that shield you from interest-rate risks. If interest rates in the economy spike after you invest in gilt funds, dynamic bond funds, medium- or long-duration funds and corporate or credit-risk funds, your NAV will usually take a hit because these funds are invested in bonds with a maturity of three years or more. Liquid-fund returns, in contrast, simply float up or down with rates in the economy.

Liquid funds are also supposed to be among the safer classes of debt funds on the default front. But after defaults and downgrades in highly rated bonds, some liquid funds have taken surprise NAV hits in the last three years. However, you can steer clear of such risks by choosing your liquid funds with care. Liquid funds are the debt-fund category with the lowest expense ratios; the cheapest ones are available at 0.10-0.20 per cent a year.

As a category, liquid funds have averaged a 7.7 per cent return over 10 years, 7.4 per cent over five years and 6.9 per cent in the last one year. While returns may be lower if market interest rates dip, liquid funds will continue to deliver a better deal than savings bank accounts.

Short-duration funds for intermediate goals
Where do you invest if you are looking to buy a car in three to five years or are looking to meet the down payment for your home? For any financial goal that is less than five years away, equity investments are a no-no because a sudden market decline after you invest can leave you with a very little time to recoup your losses.

Debt funds are a good fit for such goals because they deliver the benefits of compounding without subjecting your capital to big risks. Within debt funds, we don't recommend funds which invest in medium- or long-term bonds because interest-rate cycles are hard to predict and your fund manager getting it wrong can lead to a bumpy ride on returns.

Short-duration debt funds, which invest in debt with a maturity of one year to three years, offer a good balance between returns and risks for up to three-year goals. While riskier than bank deposits, short-duration debt funds score over them on tax efficiency. While the returns you earn on bank FDs are taxed at your slab rate, returns on the growth option of short-duration debt funds, if held for over three years, are treated as long-term capital gains and taxed at 20 per cent with indexation benefits.

Short-duration debt funds have been among the least volatile categories of debt funds, with their returns averaging 7.5 per cent in the last 10 years, 7.1 per cent in the last five and 5.3 per cent in the last one year.

Conservative hybrid funds
Are you a retiree looking for inflation-beating returns and haven't invested in equities ever? Or a conservative person looking for a long-term investment which will never subject you to capital losses? You should consider conservative hybrid funds as the suitable option for your money. Conservative hybrid funds, labelled regular savings plans by many AMCs, used to be monthly income plans in their earlier avatar. They invest 70-75 per cent of their portfolios in debt instruments, with the rest in equities.

The equity allocation works well to get you to an inflation-beating return in the long run, while the debt portion acts as a steady compounder and cushions against capital losses. Returns on this category do depend on equity markets. But these funds tend to stay in positive territory even in adverse markets. The category has delivered an 8.4 per cent return over 10 years, 7.7 per cent over five years and 4.6 per cent in the last one year.

Equity-savings funds
Equity-savings funds represent a more tax-efficient twist on conservative hybrid funds. By investing roughly one-third of their portfolio in equities, one-third in debt and one-third in debt-like arbitrage products, these funds deliver debt-like returns with equity taxation. That means that your returns after one year are taxed at just 10 per cent. Equity-savings funds are a good fit for five-year plus goals and serve the same purpose as conservative hybrid funds.

Choosing them
By sticking to the above types of debt funds, you should be able to avoid the worst of accidents in debt-fund investing. But do note that while you can reduce the impact of market risks, you cannot wholly avoid them in any fund product. While the debt categories cited above do a good job of minimising duration risks, they are susceptible to credit risks because of their corporate-bond holdings.

To steer clear of debt funds that take on higher-than-usual credit risks, you can look out for three signs. A high proportion of corporate bonds rated below AA can be one sign of high risk-taking. High portfolio yield to maturity (YTM) is another. Chart-topping funds are often the ones that take on more credit or duration risks than their peers.

Investors who don't mind giving up a bit of their returns to avoid nasty surprises should look for more middle-of-the-road funds in any debt category, rather than the chart toppers.

Finally, debt is one category where expense ratios can make a big difference to your returns. The short-duration, conservative hybrid and equity-savings categories are particularly prone to high expense ratios. So, don't forget to filter your debt funds for low costs.

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