Debt is the major markets in which people invest their hard-earned money to make profits. The debt market consists of various instruments which facilitate the buying and selling of loans in exchange for interest. Considered to be less risky than equity investments, many investors with a lower risk tolerance prefer buying in debt securities. However, debt investments offer lower returns as compared to equity investments. Here, we will explore Debt Funds and talk about different types of debt funds along with their benefits and a lot more.
In this article
What is a Debt Fund?
Debt funds invest in securities which generate fixed income like treasury bills, corporate bonds, commercial papers, government securities, and many other money market instruments. All these instruments have a pre-decided maturity date and interest rate that the buyer can earn on maturity – hence the name fixed-income securities. The returns are usually not affected by fluctuations in the market. Therefore, debt securities are considered to be low-risk investment options.
How do Debt Funds work?
Every debt security has a credit rating which allows investors to understand the possibility of default by the debt issuer in disbursing the principal and interest. Debt fund managers use these ratings to select high-quality debt instruments. A higher rating implies that the issuer is less likely to default.
The next logical question is:
Do Debt Funds also invest in low-quality debt instruments?
The answer is yes. Fund managers select securities based on various factors. Sometimes, choosing low-quality debt security offers an opportunity to earn higher returns on debt investments and the fund manager takes a calculated risk. However, a debt fund which has high-quality securities in its portfolio will be more stable. Further, the fund manager can choose to invest in long-term or short-term debt securities depending on whether the interest rate regime is falling or rising.
Who should invest in Debt Mutual Funds?
Debt funds are highly recommended to investors with lower risk tolerance. Debt funds usually diversify across various securities to ensure stable returns. While there are no guarantees, the returns are usually in an expected range. Hence, low-risk investors find them ideal. Debt funds are also available for:
- Short-term investors (3-12 months) – Rather than keeping your funds in a regular savings account, you can invest in liquid funds which offer 7-9% returns. Also, you do not compromise on liquidity.
- Medium-term investors (3-5 years) – If you want to invest in a low-risk instrument for 3-5 years, the first thing that probably comes to mind is a bank fixed deposit. Investing in a dynamic bond fund for a similar tenure tend to offer better returns than FDs. Also, if you need monthly payouts (like interest in FDs), you can opt for a Monthly Income Plan.
Types of Debt Funds
Based on the maturity period, debt funds can be classified into the following types:
- Liquid Fund – which invests in money market instruments having a maturity of maximum 91 days. Liquid funds tend to offer better returns than savings accounts and are a good alternative for short-term investments.
- Money Market Fund – which invests in money market instruments with a maximum maturity of 1 year. These funds are good for investors seeking low-risk debt securities for a short-term.
- Dynamic Bond Fund – which invests in debt instruments of varying maturities based on the interest rate regime. These funds are good for investors with moderate risk tolerance and an investment horizon of 3 to 5 years.
- Corporate Bond Fund – which invests a minimum of 80% of its total assets in corporate bonds having the highest ratings. These funds are good for investors with lower risk tolerance and seeking to invest in high-quality corporate bonds.
- Banking and PSU Fund – which invests at least 80& of its total assets in debt securities of PSUs (public sector undertakings) and banks.
- Gilt Fund – which invests a minimum of 80% of its investible corpus in government securities across varying maturities. These funds do not carry any credit risk. However, the interest rate risk is high.
- Credit Risk Fund – which invests a minimum of 65% of its investible corpus in corporate bonds having ratings below the highest quality corporate bonds. Therefore, these funds carry an amount of credit risk and offer slightly better returns than the highest quality bonds.
- Floater Fund – which invests a minimum of 65% of its investible corpus in floating rate instruments. These funds carry a low interest-rate risk.
- Overnight Fund – which invests in debt securities having a maturity of 1 day. These funds are considered to be extremely safe since both credit risk and interest rate risk is negligible.
- Ultra-Short Duration Fund – which invests in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between three and six months.
- Low Duration Fund – which invests in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between six and twelve months.
- Short Duration Fund – which invests in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between one and three years.
- Medium Duration Fund – which invests in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between three and four years.
- Medium to Long Duration Fund – which invests in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between four and seven years.
- Long Duration Fund – which invests in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is more than seven years.
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Factors to consider before investing in Arbitrage Mutual Funds in India
Here are some important aspects that you must consider before investing in debt funds in India:
Risks in Debt Funds
Debts funds fundamentally carry three types of risks:
- Credit Risk – which is the default risk of the issuer not repaying the principal and interest.
- Interest Rate Risk – which is the effect of changing interest rates on the value of the scheme’s securities.
- Liquidity Risk – which is the risk carried by the fund house of not having adequate liquidity to meet redemption requests.
Debt funds offer lower returns as compared to equity funds. Also, there is no guarantee of the returns. The NAV of debt funds fluctuates with changes in the interest rate. If the interest rates rise, then the NAV of a debt fund falls and vice-versa.
This is an important aspect while investing in debt funds. The expense ratio is a percentage of the fund’s total assets which a fee towards fund management services. Since the returns in debt funds are not very high, a high expense ratio can dent your earnings. Look for schemes with a lower expense ratio and stay invested for a longer-term.
Invest according to your Investment Plan
Debt funds are available for all durations – from 1 day (overnight funds) to 7+ years (long duration funds). Therefore, you must choose as per your financial goals and investment horizon. Many investors turn towards debt funds for regular income. Some savvy investors dedicate a portion of their investment portfolio to debt for adding stability. Whatever be the reason, ensure that you invest according to your investment plan.
Taxation for Debt Funds
In the case of Debt Funds, the taxation rules are as follows:
Capital Gains Tax
If you hold the units of the scheme for a period of up to three years, then the capital gains earned by you are called short-term capital gains or STCG. STCG is added to your taxable income and taxed as per the applicable income tax slab.
If you hold the units of the scheme for more than three years, then the capital gains earned by you are called long-term capital gains or LTCG. LTCG is taxed at 20% with indexation benefits.