Debt funds invest in instruments that offer a fixed capital flow, including treasury bills, corporate bonds, commercial papers, government securities, and other money market instruments. All these products are tradable and have a fixed maturity date and interest rate that the purchaser can obtain upon maturity of the security and therefore the reason it is termed as a fixed-income security.
The returns are usually consistent and they are not subject to changes in the market. Because of this, debt securities are considered safe investment options that constitute the backbone of the debt mutual funds.
Features of Debt Mutual Funds
As we are aware of the meaning of debt funds, we can now discuss the main features of these funds:
Suitability
Mutual funds that offer their investors stable returns in terms of debt funds diversify in a variety of securities. Though there are no assurances made, the returns tend to be within an expected range. Hence, they are ideal for low-risk investors. These are the funds which are suited to long-term, short-term and medium-term investors.
Returns
The returns of debt funds are lower than those of the equity funds. Also, there is no guarantee as to the returns. These funds depend on the fluctuation of interest rate in the Net Asset Value (NAV). As the interest rates go up, the NAV of such funds declines and the opposite holds true as well.
Risks
Debt fund investment inherently involves three primary types of risks: (Where is the thurd type of risk?)
- Credit Risk – Which refers to the risk of the issuer failing to repay the principal and interest.
- Liquidity Risk – Which pertains to the risk faced by the fund house of lacking sufficient liquidity to fulfill redemption requests.
Types of Debt Funds
Depending on durability, debt funds could be classified as follows:
Liquid Funds:
Ideal to short term investment as they are highly liquid. They invest in very short term debts.
Income Funds:
These types of funds are ideal to those who desire regular income and they invest in a combination of government and corporate securities.
Short-Term and Ultra Short-Term Funds:
These are required by those investors who wish to hold their funds in the short term, and they invest in the debt securities of shorter durations.
Gilt Funds:
These are regarded as low-risk and are largely grounded on government securities.
Dynamic Bond Funds:
These are actively managed funds that track changing market conditions and may provide greater returns.
Credit Opportunity Funds:
These types of funds invest in debt securities of varied credit quality, which can cause increased yield, but a larger risk factor as well.
Fixed Maturity Plans (FMPs):
FMPs are closed-ended investment schemes, which have a fixed maturity date and deliver a definitive time of investment.
Corporate Bond Funds:
These have the potential to provide superior returns over the government securities. They can be invested in by the investors with low risk tolerance and wish to invest in corporate bonds of high quality.
How Does a Debt Fund Work?
Debt mutual funds also invest money in listed or unlisted debt securities such as Corporate Bond as well as Government Bonds, they purchase this security at a certain amount and then sell it up at a higher price. The difference between the purchase price and the selling price reflects the increase or decrease in the fund’s Net Asset Value (NAV).
Moreover, debt funds would gain periodic interest on the debt securities it invests in. In case of debt fund returns, the funds that receive regular interest in the form of fixed income securities on a regular basis over the time, resemble equivalent bank fixed deposits which do receive interest. Day to day interest on this is added to a debt fund. When interest is paid, say once a year, then it will be divided by 365 and the resulting portion is utilised to boost the NAV of the debt fund by a small quantity on an everyday basis.
Thus, the NAV of a debt scheme depends upon the interest rates of the underlying assets as well as any changes in their credit ratings.
Debt securities experience fluctuations in their market prices as pressure in interest rates varies. Consider a case where your debt fund has a security that pays 10% interest rate and the general interest rate in the economy declines, then the new securities issued in the market would pay this lower interest rate. The prices of the underlying instruments on your fund would increase to adapt to this lower rate because it is a higher rate of coupon (interest). Therefore, the higher the value of the debt instrument becomes, the higher the NAV of your fund would become.
Who Should Invest in Debt Mutual Funds?
Debt mutual funds are an excellent alternative for those who want to have a safe and stable investment. Consider investment in a debt fund when:
- You take a conservative view about risk and are concerned about keeping your capital.
- You need a steady flow of money like retirees.
- The time frame of your investments is short to medium-term.
- You prefer professional management of funds rather than holding individual bonds.
Investing in debt mutual funds may form a major component of a diversified investment portfolio, bringing in mid-way stability and with an aim of gaining superior returns over a normal Savings Account or Fixed Deposit.
How to Pick the Best Debt Fund
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Match Fund Duration to Your Investment Goals
In case your plans are short-term (less than a year), select liquid or ultra-short-term funds. Short-term bonds are the most excellent idea in case you wish to invest during 1 to 3 years.
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Learn Your Goals
Make sure the fund will meet your financial targets. This may involve retirement or financial emergency plans.
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Monitor Risks
Although debt funds tend to be safer compared with stocks, they may also pose some dangers such as credit concerns and interest rate.
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Look Back at Past Performance
Examine its past performance across various market conditions to gain insight into how the fund has managed various environments.
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Be Advised of the Cost Ratio
Scrutinise the cost ratio because debt funds are inclined to deliver low returns. The low-fee funds have the potential of delivering you with extra capital as time proceeds.
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Learn the Implications of Taxes
You should know about the taxes that are going to impose on your debt fund investment. It is applied on short-term benefits, which is charged as per your income tax bracket.
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Check Out the Fund Returns and History
Need to look at the past performance of the fund. Select a fund that has acknowledged stable returns in debt funds within the past 5-10 years.
Important Points to Consider Before Investing in Debt Mutual Funds
There are some useful things to keep in mind when planning how to invest in debt funds:
Fund Returns
Examine the history of returns of the long term debt funds, look at three, five, or even decade long periods, and see whether they have consistently outperformed, during their different periods, benchmarks and related funds. However, it is important to align the fund’s past investment objectives, keeping in mind that historical results do not guarantee future outcomes.
Fund History
Strategize with fund companies that exhibit a great record of good performance of at least five to ten years in the investment sphere.
Expense Ratio
Enquire about the percentage of investment that is allocated to fund management fees in the debt fund. Cheaper expense ratios will provide you with improved net returns.
Financial Ratios
Evaluate funds based on metrics such as standard deviation, Sharpe ratio, alpha, and beta. The greater the Sharpe ratio, the greater the returns per risk incurred.
All these elements play an important role in developing an intelligent approach when making an investment decision on debt funds.
Why Should Everyone Need to Invest in a Debt Mutual Fund?
The debt fund investment is mainly encouraged due to four reasons which are:
Professional Expertise and Profits
By purchasing a debt mutual fund, an investor can get an interest as well as a capital gain. It offers entry to retail investors in the capital markets and wholesale debt markets where these investors cannot invest directly.
Investment Options
Debt mutual funds can be found at every point of the maturity / credit risk curve. The short-term funds give consistent income and the longer-term funds give interest and capital gain, which are part of the risk of the person dealing with NAV fluctuations.
The securest debt securities are primarily purchased by overnight funds, liquid funds, corporate bond funds and the short-term funds. uUltra-short and short-duration funds may take on a certain degree of credit risk to enchance their returns.
Low Risks
Investment in debt funds is less risky as compared to equity. To lower overall risks and enhance stability investing in top performing debt mutual funds can bring benefits in your portfolio.
Liquidity
These deposits are very liquid and can be withdrawn in one or two business days following a redemption request. There is no need to lock in funds for a long term as compared to FDs or RDs. Although an exit fee is charged by some funds, there are no penalties when withdrawing your money invested in debt funds.
Taxation Rules of Debt Funds
Regarding debt mutual funds, the taxation regulations are:
Short-Term Capital Gains (STCG):
You get short term capital gains when held up to 3 years and these gains will be added to your total taxableincome and will be taxed as per your income tax bracket.
Long term capital gains (LTCG):
Gains exceeding 3 years get taxed as per your income tax slab, without benefits of indexation.
How Debt Funds Differ from Other Mutual Fund Schemes
Debt mutual funds are not fully different in comparison to other mutual fund schemes as far as operations are concerned. They are however safer, in general, than equity mutual funds.
The NAV of equity funds can decline significantly with drop in the markets, but debt funds are more stable. With that said, returns of a debt fund are moderate in comparison to equity funds which may provide a higher long-term change with additional risk.
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