Investing in debt funds ensures low-risk income against market exposure involved with equity investment. The issuer pays pre-decided interest, payable at maturity. Hence, these are also called fixed-income investments.
What are Debt Funds?
When companies or the government need money, they raise it from the market in forms of bonds. So, when you purchase bonds, you are actually lending money to these entities. Debt funds are types of mutual funds that invest in fixed-income generating debt instruments.
Debt funds are great investment products, especially for investors with a low-risk appetite, who want to generate a steady stream of income from their investment. If you have been saving in traditional saving instruments like FD or savings account, debt mutual funds are better options as it helps you get better returns.
How Does The Debt Funds Work?
Debt funds invest in a variety of fixed income securities like bonds and treasury bills, including gilt funds, and various monthly income plans, short term plans, and fixed maturity plans. A debt fund manager selects from the sea of debt plans available in the market that offer the highest return and carry high credit rating.
Credit rating refers to the rating given to various debt instruments by credit rating agencies that signify the issuer’s risk of default to pay back the debt. A higher rating means higher credibility. The fund manager invests in funds that carry the highest rating to ensure regular interest payment and maturity. Debt funds investing in higher-rating debt instruments are less volatile and attractive to fund managers and investors alike.
Debt fund managers devise their investment strategies to generate a robust return for the investors, which prompts them to select long-term debt plans when interest rates are falling, and short-term plans when it is high.
Types Of Debt Funds
There are several types of debt mutual funds available for investment. Based on maturity and the instruments they invest in, debt funds are of the following classes.
Dynamic Bond Funds
It is dynamic because the portfolio composition keeps changing to adjust to the changing interest regime. Dynamic bond funds have different maturity since they invest in both long-term and short-term debt instruments depending on the interest rate.
Dynamic debt funds suit investors with moderate risk appetite with an investment horizon of 3-5 years.
Liquid Funds
liquid fund MFs invest in bonds with a maximum maturity of 91 days. These bonds offer a better return than traditional savings accounts over a short time.
Money Market Funds
These debt mutual funds invest in different money market instruments with a maximum maturity of one year, suitable for investors with a short-term investment plan.
Corporate Bond Funds
These funds invest up to 80 percent of the corpus into various corporate bonds with the highest rating to generate a higher return. These are good instruments for investors with low-risk tolerance.
Income Funds
As the name implies, income funds aim to generate income over a long term. Therefore, invest in long term bonds and debt instruments. Income funds have an average tenure of five to six years, making them more stable than dynamic bonds.
Short-term and Ultra Short-Term Funds
These funds have an average maturity of one to three years. These funds generate a stable return for investors seeking low-risk return for short-term.
Gilt Funds
Gilt funds invest in government-backed securities with a very high rating and low credit risk. Since a government will seldom default, these funds attract risk-averse investors who seek fixed-return on investment.
Banking and PSU Funds
Fund managers allot at least 80 percent of the corpus in different banking and PSU sector companies generating a steady, low-risk return on investment.
Credit Risk Funds
In credit risk funds, around 65 percent of the corpus gets allocated to less pristine credit rating funds, hence they carry a higher risk than other debt mutual funds but also generate a better return.
Floater Funds
Fund managers allocate around 65 percent of the corpus to various floating rate instruments. In the scale measuring risks of debt funds, these are low-risk investments.
Fixed Maturity Plans
Fixed-maturity plans come with a lock-in period. You invest in these plans for a specific duration and receive a fixed return on maturity. These funds invest in various corporate and government bonds, which are low-risk.
The above list contains a broad classification of debt funds. But apart from these, there are several other combinations of debt mutual funds available for investment. We suggest you get clarity on the available options before investing in the best one.
Advantages Of Debt Funds
There are multiple advantages to investing in debt funds.
- Debt funds are the best for investors with low risk-appetite who want a steady and assured return
- Adds stability to your portfolio as well helps in diversification to ensure a balanced return in all market condition
- No deduction of TDS or taxes. Taxes apply if an investor sells or withdraw fund units, depending on the length of the investment period
- Debt funds generate a better return than traditional savings plans like Fixed Deposit
- Offer cost advantages to investors as the charges are low compared to other mutual fund investments
Debt mutual funds have evolved and modernised to offer a wide range of short and medium-term investment opportunities.
Short-term debt funds
Liquid funds offer both liquidity and higher return for short-term investors. These funds have generated an average of 7 to 9 percent return.
Medium-term debt funds
Investors looking at an investment horizon of three to five years can choose dynamic debt funds to invest in. These funds are designed to ride interest rate volatility to generate a healthy return on investment.
Investors looking to create an alternative source of income can choose debt funds that are Monthly Income Plans (MIPs).
Things To Consider
Here are a few things to consider regarding investing in debt mutual funds.
Risk
Debt funds are low risk, but they are still riskier than fixed deposits in banks. These funds invest in various debt instruments in the market, hence, carry an inherent risk associated with market volatility and interest rate regime.
Return
The net asset value (NAV) of the investment will impact your return from these funds.
Fees
To invest in debt mutual funds, you have to pay an expense ratio. SEBI has fixed the upper limit for the same at 2.5 percent.
Investment Period
Debt funds come with various maturity periods and even lock-in periods. Investors would need to select plans that suit their financial goal.
Tax
Capital gains from debt funds are subject to capital gain tax. Short-term capital gain is charged on investment for less than three years.
Recent situation
Return on debt funds depends on two factors – future interest rate and the price of the bonds. The price of bond instruments depends on economic conditions. When the economy is booming, companies can spend more to cater to the rising demand side. It fuels demand for funds, and companies borrow more, resulting in rising interest rates as demand for credit rises. On the contrary, in a contracting economy, demand for credit goes down as consumers start to spend less. The excess of credit then actually lowers the interest rate. To revive the economy and encourage businesses to avail loans, the government also reduces the lending rate, causing the price of debt instruments to shoot up.
Since bond price moves in the opposite direction of the interest rate, a higher long tenure bond requires little funds invested in short tenure bonds, which causes the current rate to fall. Investors begin to anticipate the rates to decline further in the future, which causes the current rates to increase. A similar situation occurred when the pandemic ravaged the nation’s economy last year. But surprisingly, debt mutual funds yielded in the negative, which left many of the investors baffled.
During August 2020, most debt funds produced negative returns as sinking GDP and lowered GST collection, along with rising inflation, put pressure on its yield. Foreign portfolio investors were selling heavily in both the debt and money markets, and there was increasing pressure from domestic investors to withdraw from the mutual funds amid rising uncertainties. The supply of funds in the economy also shrunk as banks were trying to keep their NPA low. It reduced the availability of cash in the market. Collectively these factors created a negative situation for the debt funds and impacted the NAV value, which fluctuates daily based on market movements.
Who Should Invest in Debt Funds?
Here’s who should consider investing in debt funds.
- Conservative Investors: Debt funds are ideal for investors who prioritise capital preservation and are risk-averse. These funds primarily invest in fixed-income securities like government bonds, corporate bonds, and money market instruments, which are generally considered lower risk compared to equities.
- Income-Seeking Investors: If you rely on your investments to generate regular income, debt funds can be a suitable choice. Many debt funds distribute interest income to investors periodically, making them a source of consistent cash flow.
- Short-Term and Medium-Term Goals: Debt funds are well-suited for investors with short-term or medium-term financial goals, such as saving for a down payment on a house, funding education expenses, or preparing for retirement. They offer relatively stable returns over these time horizons.
- Capital Protection: Investors concerned about protecting their capital and minimizsing the impact of market volatility may find debt funds attractive. These funds aim to provide a steady return with lower fluctuations in value compared to equity investments.
- Portfolio Diversification: Debt funds can be used as part of a diversified investment portfolio. By including fixed-income securities in their portfolio alongside equities, investors can spread risk and achieve a more balanced asset allocation.
Invest According to Your Investment Plan
As debt funds are available in various durations, i.e., from 1-day to over 7 years, it is important to consider your investment horizon while picking the right fund. Whether seeking regular income or stability, select debt funds that are in line with your financial objectives and investment horizon.
Tax on Debt Mutual Funds
According to the Finance Bill 2023, the taxation on debt mutual funds is as follows:
- Funds acquired on or after April 1, 2023, gains are added to the investor’s income and taxed as per their tax slab, irrespective of the holding period of the funds.
- Funds acquired before April 1, 2023, are taxed according to the holding period, i.e.,
- Long-Term Capital Gains (LTCG) – Funds held for more than 3 years are taxed at 20% (plus applicable surcharge and cess) with an indexation benefit.
- Short-Term Capital Gains (STCG) – For the funds held for less than 3 years, the gains are added to the investor’s income and taxed as per their income tax slab.
Remedies offered by the RBI
Whenever the Indian economy had struggled to find a foothold, RBI, as the central bank, came to the rescue. It was no different in the current scenario. RBI came to the rescue of debt fund investors by purchasing government securities from the market, which increased cash flow in the economy. It also trimmed repo rate and reverse repo rate to ease the pressure from the banks. Lower interest rates attracted borrowers and normalised the liquidity crunch created by the pandemic. Side-by-side, RBI also increased the supply of the US dollar into the foreign exchange market to strengthen the Indian rupee.
It introduced LTRO or Long-term Repo Operations to encourage banks to invest in bonds and commercial papers to boost the demand for these products. These impacted debt mutual funds and improved NAV.
Conclusion
When interest rates come down in the market, investors start putting their money in the debt fund. But as the economic uncertainties rise, it impacts the creditworthiness of the borrowers. Investors can safeguard their capital by investing in government securities, banking and PSU funds, and corporate bond funds as these are relatively safe since the chances of default are minimal.
Lastly, select a fund based on your risk appetite and investment horizon. If the investment need is immediate you can put the funds in overnight funds or a liquid fund over long-term investment funds.
FAQs
How do debt funds work?
Debt funds pool money from investors and invest it in a diversified portfolio of debt instruments. The returns generated by these funds come from the interest earned on the underlying securities.
How debt funds are better than FD?
Debt fund offers higher returns than bank Fixed Deposits. Debt funds also offer higher liquidity and preservation of principal.
Is it good to invest in debt funds?
Debt funds can suit a variety of investors, from risk-averse investors to those looking for short-term investment options.
Are debt funds high-risk?
Debt funds are low risk compared to equities, but they are exposed to interest rates, credit ratings, and inflation risks. The longer the duration of maturity, the higher the interest rate risk.
How can I invest in debt funds?
To invest in debt funds, you can typically open an account with a mutual fund company or a financial institution offering mutual fund services. You can choose a debt fund based on your investment goals and risk tolerance, invest a specific amount, and monitor your investment through periodic statements provided by the fund.
