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Debt funds are mutual funds that invest a pool of investors’ money in fixed-income securities including Government & corporate bonds, debentures, and other money-market instruments. 

Debt funds are termed safer investment options for conservative investors since they offer minimal risk albeit low returns compared to other mutual fund schemes. However, like other mutual fund schemes, debt funds also come with their own set of risks. 

Here are some factors that could impact the returns from debt scheme that investors should note before investing in debt funds:

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  • Interest rate fluctuations 

Fixed investment securities are structured in such a manner that they react inversely with interest rates. A rise in the interest rate will trim the returns on fixed investment, while a dip in the interest rates will result in better returns. Let’s understand this better. For instance, a bond’s coupon rate is fixed at the time when the bond is first issued, say 6%. So if the interest rates fall (below the coupon rate) to say 5.5%, the bond looks more attractive as it carries a higher interest (than the current market interest rate). So the price of the bond starts to rise as more people start buying. The situation is reversed, if the interest rates start to rise. 

The longer the maturity period of the security, the greater is the risk that the interest rate may change during the period. However, given the slow growth of interest accumulation, investors may need to keep a long investment horizon to actually experience significant capital appreciation. Debt funds offer the flexibility of entry and exit from the fund, however, they too are subject to the interest rate risk.  

  • Credit ratings of the funds

Independent rating agencies provide ratings to different funds after analyzing their creditworthiness and capacity to pay back. Funds rated AAA are considered ‘super safe’ and have the lowest credit risk, meaning the fund has a higher probability of earning good returns on your investment. Those having a C rating are the most exposed to credit risks, and investors may want to research well before considering an investment in such funds.

  • Time period

The choice of funds should depend on the objective of your investment. You can align your short term and long term needs depending on the tenure of the mutual fund. For Example, most investors choose short term debt fund, ultra short or liquid funds for immediate needs. This will also diversify your mutual fund portfolio, as having different funds with different maturity horizons ranging from short-term to long-term will ensure adequate liquidity. 

  • Expense ratio

If a debt fund yields 8% returns, investors won’t receive the complete 8%. This happens because the mutual fund house or the AMC has to deduct their operating fees and overhead costs. These expenses are known as the expense ratio of the mutual fund. Investors may want to watch out for the percentage the fund house deduct as expense ratio and pick funds with a low expense ratio to minimize returns.

  • Returns are not guaranteed

Even though debt funds are fixed investment securities like FD’s and invest massively in government securities, the returns are not guaranteed! Market risks, credit risks, liquidity risks, and interest rate risks can be detrimental to the performance of debt funds. 

  • Long-term taxation benefit

Debt funds held for less than a year accrue a short-term capital gains tax. The gain is added to your income and taxed as per your income tax slab. 

Debt funds held for over a year accrue a long-term capital gains tax of flat 20% with indexation benefits. 

Conclusion

Over the past few years, the market went through multiple events that reminded investors of the ever-important ‘Mutual funds are subject to market risks’. That being said, the benefits offered by debt funds like fairly predictable returns, long-term taxation benefits, high liquidity, convenience, and regular income make debt funds a popular choice for investors, especially high net worth individuals looking to protect their wealth and retail investors with a low-risk appetite. 

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Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. NBT do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.