Debt Funds Explained: Types, Benefits, Taxation and Risks

Debt funds have become a popular option for conservative investors seeking stable income. The debt market instruments facilitate buying and selling of loans in exchange for interest. There are more than 10 types of debt mutual fund schemes that one can consider. Considered to be less risky than equity funds, investors with a low-risk appetite prefer debt funds. However, debt fund returns could also be relatively lower due to the lower degree of investment risk.

Here, we’ll be exploring them in detail, along with the benefits, taxation, and potential returns. Let’s dive in!

What is a Debt Fund?

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 Fund: 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 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

How Do Debt Funds Work?

Debt funds generate returns by investing in debt and money market instruments. After buying these securities, fund managers sell them at a margin. The difference between the cost and selling price positively/negatively impacts the NAV of the fund.  

The rise or fall in interest rates directly impacts the price of the underlying securities. For example, a debt fund invests in bonds that yield 8% interest. In a falling interest rate regime, the issuer will offer new bonds at a lower coupon rate, say 6%. However, the price of the underlying securities will increase as investors will continue to benefit from the higher interest rate till the bonds expire.

With the increase in the value of the debt instruments, the fund’s net asset value (NAV) will continue to rise. However, note that if the interest rate in the economy rises, it will negatively impact the price of the underlying financial instruments. 

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

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. 

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:

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.  

Liquidity risk

This risk is borne by a fund house as it might not have sufficient liquidity to fulfil investors’ redemption requests. 

Interest rate risk

If the interest rate rises, the price of debt instruments drops, which leads to a decrease in the fund’s NAV. 

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. 

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. 

Since investors are not actively involved in all buy-and-sell decisions, the risk is comparatively lower. Navi Nifty 50 Index Fund has the lowest expense ratio (0.06%), which enables investors to maximize their net returns upon redemption. 

Visit www.navimutualfund.com to start investing.

How to Choose a Debt Mutual Fund?

Here are the parameters for choosing a debt mutual fund to invest in:

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.

Interest Rates

Debt mutual funds are affected by interest rates. Higher interest rates lead to a fall in bond prices. With the increase in interest rates, new bonds are issued that have a higher yield. As a result, the older bonds become of lower value. The Net Asset Value (NAV) also gets affected by these ‘older bonds’. High-interest rates also affect the long-term debt mutual funds. Investing in small-term debt funds during this time would be a safer bet at this time.

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.

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. 

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. 

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.

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 in a debt fund 3 years from the date of purchase, they earn short-term capital gains (STCG) upon redemption. These are added to the overall income of an investor and are taxed as per the applicable slab rate.

Long-term Capital Gains

In case the holding period is more than 3 years, the gains are termed as long-term capital gains (LTCG). A tax rate of 20% is applicable to them. Also, investors are eligible for indexation benefits in this case.

Also read: Capital Gain Tax on mutual funds

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.

In case you want to invest in low-cost funds, explore index funds Navi Mutual Fund. Download the Navi app today and choose the fund that suits your investment goals.

Frequently Asked Questions

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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.