Debt Funds – Types, Benefits, Risk and Taxation
Are you a risk-averse investor looking to invest in mutual funds? Have you considered investing in debt funds? To give you a brief intro – debt funds are basically mutual fund schemes that majorly invest in fixed-income securities like monthly income plans (MIPs), short-term plans (STPs), liquid funds, and fixed maturity plans (FMPs), among others. Still not sure how investing in debt funds would help you grow your money? Let us clear the air for you.
In this article, we have dissected the concept of debt mutual fund schemes, their benefits, types and workings so that you can make an informed investment decision. Let’s dive in!
What are Debt Funds?
Also called bond funds or fixed-income funds, debt mutual funds allocate their investment corpus (pool of money) to fixed-income securities. These can include corporate bonds, commercial paper, treasury bills, money market instruments, government bonds, certificates of deposits, dynamic bond funds, and more. All these financial securities come with a predetermined maturity period and interest rate.
Consequently, market fluctuations do not impact the performance of debt schemes, making them a low-risk investment option.
Also read: Equity Fund Vs Debt Fund
Different Types of Debt Funds
Here are the various types of debts funds in India:
Note: AA+, AA, etc., are credit ratings of mutual funds declared by respective Asset management companies (AMCs).
1. Money Market Fund
This is a debt fund that allocates its investment corpus to money market instruments having a maturity period (Macaulay duration) of not more than one year.
2. Liquid Fund
Liquid funds invest in money market instruments that have a maximum maturity period of 91 days.
3. Corporate Bond Fund
These debt mutual funds invest a minimum of 80% of their fund corpus in corporate bonds that are rated AA+ and above.
4. Dynamic Bond Fund
These funds allocate their financial assets to debt instruments having different maturity periods depending upon the interest rate regime.
5. Credit Risk Fun
Credit risk funds invest at least 65% of their fund corpus in corporate bonds that are rated AA or below.
6. Banking PSU Fund
These mutual fund schemes utilize a minimum of 80% of their financial assets to purchase debt instruments issued by public sector undertakings and banks.
7. Gilt Fund
Gilt funds invest at least 80% of their financial resources in government securities across different maturities.
8. Long Duration Fund
These funds invest in debt instruments and money market securities having a maturity period of more than 7 years.
9. Medium to Long Duration Fund
These schemes allocate their funds to money market and debt instruments where the Macaulay duration of the portfolio ranges from 4 to 7 years.
*Macaulay duration refers to the time taken by a fixed-income instrument to repay its cost through cash flows.
10. Medium Duration Fund
These Mutual funds allocate their funds to the money market and debt instruments such that the Macaulay duration of the portfolio is between 3 to 4 years.
11. Short Duration Fund
Short-duration funds invest in debt and money market securities in a manner that the scheme’s Macaulay duration ranges from 1 to 3 years.
12. Low Duration Fund
These funds allocate their pool of money to debt and money market securities in a way that ensures that the Macaulay duration of the portfolio is anywhere between 6 to 12 months.
13. Ultra Short Duration Fund
Ultrashort duration schemes invest in debt and money market securities in a manner that their portfolio’s Macaulay duration is between 3-6 months.
14. Overnight Fund
This type of mutual fund scheme allocates its pool of money to debt instruments having a maximum maturity period of 1 day, such as reverse repo (repurchase agreement).
15. Floater Fund
Floater funds invest at least 65% of the investment corpus in floating-rate securities, for example, certificates of deposit. Such securities offer interest rates that keep changing periodically.
Also read: Best Short Term Debt Funds
What are the Benefits of Debt Funds?
Here are the benefits of debt funds:
1. Higher returns compared to fixed deposits
Debt funds have the ability to generate higher returns than bank fixed deposits and savings accounts.
2. High liquidity
Debt funds, especially liquid funds, are easily convertible into cash. If a financial emergency arises, investors can redeem their units quicker in comparison to other investment options, such as fixed deposits.
3. Tax-efficient
In the case of debt mutual funds, individuals are eligible for Indexation benefits. Also, there is no TDS for this investment avenue.
4. Can be combined with equities
Investors looking to make profits in a bearish market can combine debt funds with equity investments to minimize losses.
5. Low cost of investment
As per SEBI regulations, the expense ratio of debt funds cannot be more than 2%. Overnight funds and liquid funds charge an extremely low expense ratio, whereas dynamic bond funds and long-duration funds impose a higher expense ratio.
Besides these, debt funds can be effective as a hedge against volatility in the stock market.
Also read: 10 Best Debt Mutual Funds To Invest In
What Are the Risks Associated with Debt Funds?
Although debt funds are independent of the stock market volatility, they carry different types of risks. Some of them are discussed in detail below:
1. Credit risk
This refers to the probability that the issuer of the debt or money market instruments might not be able to repay the principal and interest amount.
2. Liquidity risk
This risk is borne by a fund house as it might not have sufficient liquidity to fulfil investors’ redemption requests.
3. Interest rate risk
If the interest rate rises, the price of debt instruments drops, which leads to a decrease in the fund’s NAV.
4. Market risk
Certain types of debt mutual funds, for example, dynamic bond funds, are associated with specific risks. For instance, fund managers of these schemes update the portfolio depending upon the change in interest rate. In case their decision turns out to be incorrect, it could lead to losses for investors.
5. Returns on Debt Funds
In comparison to equity schemes, debt funds provide lower returns to investors. Also, there is no guarantee of returns owing to the various types of risks. However, these funds have the potential to generate higher returns than a bank fixed deposit or a savings account.
That said, if the goal of an investor is to earn higher returns without investing in traditional equity schemes, he/she can allocate funds to an index fund.
An index fund is a passively managed fund that replicates the performance of a benchmark index, such as the Nifty 50. So, if you want to reap the benefits of investing in the best index fund schemes, start investing with Navi Mutual Fund. Navi offers a wide range of low-cost index funds designed for investors having various levels of risk tolerance and different investment goals. All you need to do is download the Navi app and choose the fund of your choice. Happy investing!
Disclaimer: Mutual fund investments are subject to market risks, read all scheme-related documents carefully.
Who Should Invest in Debt Funds?
Individuals may choose to park money into debt funds if:
- They want to invest in an avenue that is not as risky as equity funds
- They are looking to earn higher returns in comparison to a bank fixed deposit or a savings account
Debt funds are also available to these investors:
- Short-term investors: Investors who invest in liquid funds instead of keeping their money in the bank. They invest their money for 3-12 months.
- Medium-term investors: If someone wants to invest in risk-free securities for a period of 1-3 years with a better return than FDs, investing in a dynamic fund is a good option.
Thus, to sum it up, debt funds are suitable for risk-averse investors who prefer earning stable returns rather than seeking maximum capital appreciation.
Taxation on Debt Funds
The tax applicable on debt funds depends on the holding period, which refers to the duration for which individuals choose to park their funds in a debt scheme. Let’s take a closer look.
Short-term Capital Gains
In case investors sell their units of a debt fund 3 years from the date of purchase, they earn short-term capital gains (STCG) upon redemption. These STCG are taxed based on the income tax slab you fall under.
Long-term Capital Gains
In case the holding period is more than 3 years, the gains are termed long-term capital gains (LTCG). Earlier, a tax rate of 20% was applicable on LTCG with indexation benefits. However, as per the amendments made in Budget 2023, no benefit of indexation for the calculation of LTCG on debt funds would be made available for investments made on or after 1 April 2023. This is applicable for those funds where equity investments are less than 35% of the corpus. In such cases, returns will be taxed as per the investor’s tax slab.
Also read: Capital Gain Tax on mutual funds
How to Invest in Debt Funds?
You can easily invest in debt mutual funds via online or offline methods. You can invest directly through the website of AMC (asset management company) or through intermediaries like brokers and distributors. Other options to invest in debt funds include investing through a Demat account or registrars such as CAMS and Karvy.
Here are the easy steps to directly invest in debt mutual funds online.
Step 1: Open a new account on AMC’s website.
Step 2: Provide your details for the investment procedure to begin investing.
Step 3: Fill up the FATCA form.
Step 4: Provide your bank details.
Step 5: Upload an image of a previously cancelled cheque.
Step 6: Complete your KYC verification using your Aadhaar Card and transfer money.
Alternatively, you can directly invest through an aggregator.
Things to Consider as an Investor before Investing in Debt Funds
Investors should keep these factors in mind before choosing a debt fund to invest in:
1. Know about the Risks
When choosing a suitable debt fund, investors must be aware of the risks involved with such investments. Interest rate risks and credit risks are the two main types of risk that will affect your decision.
The prices of bonds are inversely proportional to the market interest rates. Therefore, the NAV (Net Asset Value) of debt funds tends to fall whenever there is an increase in interest rate. This impacts the returns of debt funds, especially for long-duration funds.
Credit risk refers to the risk of an issuer of a debt security failing to pay the principal or interest amount in time. Such defaults can lead to the loss of investment and reduced returns. Investors should check the credit ratings of debt securities held by a debt fund to make sure that there are low credit risks.
2. Diversification
When investing, it is a well-known convention to avoid storing all your eggs in the same basket.
This thumb rule also applies in the case of debt funds. It is a good idea to diversify your investments across different types of debt instruments and maturity periods. Allocating some funds to equity investments is another good idea as it adds higher alpha to your portfolio while taking some risks.
Therefore, plan your investment strategy, maintaining a diversifying approach to gain an extra edge on your returns.
3. Sound Knowledge of different Debt Funds
Potential investors need to do thorough research on the different types of debt funds. This includes checking the funds’ past performances, ratings, investment objectives, risk levels, etc.
This will help you make a choice as you can figure out which debt fund is suitable for your risk appetite and financial needs.
4. Investor’s Risk-taking Capacity
Investors should be fully aware of their risk-taking capacity before investing in a debt fund. In addition, they must remember that risks are directly proportional to your return expectations.
For instance, dynamic funds can be equally rewarding and risky investments. Therefore, investors can invest if they accept the chances of losses in the short term. However, if a large financial loss can disrupt your financial goals, you can opt for medium or short-duration funds. These are comparatively low-risk investments. However, they bring low returns on investment.
An investor can try to strike a balance between low-risk and high returns on their overall portfolio. This will also increase the diversification of his/her portfolio.
5. Expense Ratio
Expense ratio is the fee charged to investors by fund houses annually. Higher the expense ratio, the lower the returns. Choose a debt mutual fund that has a lower expense ratio.
6. Duration of Maturity
Check the average duration of maturity in order to avoid taking unforeseen investment risks. Depending on your financial goal – whether you want returns within a few days, months or a year, you can check the maturity duration and invest in the funds that align with your goal.
7. Credit Quality
Checking the credit quality of the bonds can help you choose the best debt fund. Depending on the bonds’ ability to yield returns, they are assigned a credit rating. AAA is the best credit rating and is considered a safe investment.
8. Portfolio Yield
Interest income generated by a bond is known as the portfolio yield or current yield. Bonds with higher coupon rates are considered to have a high portfolio yield. The parameter Yield to Maturity (YTM) of debt mutual funds indicates the running yield. Before investing, know how this extra yield is being generated. If it is generated at the cost of low portfolio quality, it may not be the best debt fund to invest in.
9. Check AUM
AUM or Assets Under Management is a strong indicator of the fund’s performance. It refers to the market value of assets at a given point in time and includes the returns a fund has created as well as the capital a fund manager has to invest in new funds. Funds with higher AUM are considered to be safer to invest in.
Final Word
Debt funds are an ideal option for conservative investors who are seeking high returns along with high liquidity. That said, they must be aware of the different types of debt and money market instruments before investing in a debt fund.
Frequently Asked Questions
The process of investing in debt funds is the same as investing in any other mutual fund. One can invest directly via the AMC or through various investment platforms.
Investors whose investment horizon is 1-3 years and who are looking for a stable income will benefit from short-term debt funds. In addition, first-timers or people with low-risk capacities can opt for short-term debt funds.
Liquid funds, ultra-short duration funds, corporate funds, and low-duration funds are the types of debt mutual funds.
Similar to CIBIL scores, credit ratings in debt funds determine a business or company’s creditworthiness. It is based on a company’s capacity to generate returns to fulfil its financial commitment. The credit ratings of debt funds range from AAA to D.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
