When a debt-issuing company or organization wants to raise money, it "borrows" money from an investor in return for stable and regular interest payments. This is a simple explanation of how debt mutual funds work.
What is a Debt Fund?
The purchase of debt funds means lending money to the issuer and making investments in government or corporate bonds, treasury bills, or other market products. The objective is to enhance capital valuation and earn a stable interest. The debt issuer predetermines the interest rate and duration of the investment, which is why these funds are also called "fixed income" securities.
The Working of Debt Funds
Investors invest in several securities based on their creditworthiness. The security's credit quality represents the risk in paying the returns guaranteed by the issuer of the debt security. The fund manager that supervises the fund guarantees that you will invest in quality credit products.
A high credit rating signifies that the company is eligible and tends to pay the interest on its debt regularly and repays its principal on time. In this case, the investment is less volatile than the securities that are rated low. In addition, this period depends on the fund manager's strategy and the general interest rate system in the economy. Lower interest rates will encourage fund managers to invest in securities that are long-term, while higher rates of interest lure the investor to invest in short-term securities.
Who Should Be Interested in Investing in Debt Mutual Funds?
Conservative investors who want to invest for a short or medium-term should invest in debt funds. Fixed income funds seek to maximize returns by investing in all types of securities. This allows the loan funds to get a decent return, which is not guaranteed. The short term ranges from three months to a year, and the medium-term ranges from three to five years.
- Short-term debt funds
For short-term investors, liquid funds can be an ideal investment rather than depositing money in a savings account. They offer higher yields in the range of 7% to 9%, along with similar types of liquidity to meet urgent needs.
- Medium-term debt funds
Dynamic funds are apt to offset interest rate volatility as they offer higher yields than five-year bank fixed deposits. You could also opt for a monthly income plan for a stable income, making this option ideal for risk-aversive investors.
Types of Debt Funds
There are several types of debt mutual funds suitable for different investors:
1. Dynamic Bond Debt Funds
As the name implies, investing in these funds means that fund managers constantly change their composition according to the fluctuating interest rate. Dynamic bond funds receive interest payments and invest in products with longer or shorter maturities, so the average maturity varies.
2. Income Funds
These funds invest primarily in long-term-maturity bonds and consider interest rates. Hence, they are more stable. The average duration of an income fund is about five to six years.
3. Short-Term and Ultra-Short-Term Debt Funds
These are fixed-income funds that invest in products with maturities ranging from one to three years. Short-term funds are ideal for risk-averse and conservative investors as they are less susceptible to interest rate fluctuations.
4. Liquid Funds
Liquid funds are risk-free and invest in debt securities with a maturity of 91 days or less. They rarely produce poor returns and are better than recycling accounts as they have higher returns and almost the same liquidity. Many companies offer debit cards for the immediate redemption of liquid funds.
5. Gilt Funds
Gilt funds are highly rated and invest primarily in government securities generating a very low credit risk. Governments rarely default, so they borrow in the form of debt certificates. Gilt funds are ideal for investors who are risk-averse and would only like to go for fixed-income. These funds invest at least 80% of their assets in government securities with various maturities.
6. Credit Opportunity Funds
These funds do not invest according to the maturity of their debt products but seek higher returns by holding lower interest rate bonds with higher interest rates by taking credit risk. Credit opportunity funds are relatively risky.
7. Limited Time Plan
A Fixed Maturity Plan (FMP) is a closed debt fund. These funds invest in debt bonds for a few months or even years. However, you can make an investment in the first offer period. It's like a fixed deposit, which can provide good tax-effective returns, but it doesn't guarantee high returns.
8. Overnight Funds
These funds invest in securities with a one-day maturity, carry low credit and interest risks, and are considered relatively stable.
9. Money Market Funds
These funds invest in money market securities and are an excellent alternative for storing surplus funds for up to a year. They are also known as emergency funds because they generate better returns and are more liquid than traditional means.
10. Banking and PSU Funds
Banks and PSU funds invest at least 80% in banks, PSUs (Social Companies), public financial institutions, local government obligations, and Municipal securities assets.
Advantages of Debt Funds
Debt funds do not have a lock-in period and can be switched to be subjected to the appropriate exit load. Debt funds are considered liquid because investors can immediately withdraw up to Rs. 50,000 per day.
2. Tax Efficiency
Debt funds are only taxed if redeemed, and TDS is paid only for the interest income earned. Dividends heated by bond funds are taxed on investors according to the investor control plate. Debt funds can gain an LTCG (long-term capital profit) of 20% if you retain the funds for three years, giving you better tax returns.
Debt funds are less volatile than equity funds and provide stability in the investor portfolio. This helps to diversify the investment portfolio and incorporate overall risks.
4. Possibility of an Excellent Income
Investment in bond funds may produce a better return. Investors also account for the changes in interest rates by determining the appropriate funds for their risk appetite, investment horizon, and earning income.
Important Considerations Before Investing in Debt Mutual Funds
- Risk - Debt funds have interest and credit risks which are more volatile than bank FDs. Rising interest rates can cause bond prices to fall.
- Returns - Debt funds do not offer guaranteed returns. The NAV or Net Asset Value of a debt fund tends to decrease as interest rates across the economy rise. Therefore, they are suitable for low-interest rate regimes.
- Cost – You must consider the cost ratio. SEBI limits the cost ratio to less than 2.25% of total assets. Given the low returns of debt funds compared to equity funds, long-term holdings help recover lost money through cost ratios.
- Investment period - If you have a short-term investment period of three months to a year, you can rely on a liquid fund. Conversely, short-term fixed-income funds typically have a two to three-year maturity period. Dynamic bond funds are ideal for three to five years. The returns are higher if the investment duration is longer.
- Financial goals - Debt capital can be used to supplement salary income. In addition, future investors will be able to invest some in credit funds to maintain liquidity. Retirees can invest more in debt funds to receive retirement benefits.
- Tax on returns - Capital gains are taxable, and the rate depends on the investment period. Capital gains achieved in less than three years are called STCGs - short-term capital gains. Capital gains achieved over three years are called LTCGs - long-term capital gains. STCG from a debt fund is subject to a fixed tax of 20% after indexing.
- Tax on profit – Income from dividends is taxed at your income tax rate. Earlier, dividends of up to Rs 10 lakhs per year were exempt from tax, depending on the holding period. If the holding period is less than three years, short-term capital gains are taxed on the investors’ tax slab. The gain achieved after a three-year holding period is called long-term capital gains, which are taxed after indexation at 20%.
How to Invest in a Debt Fund?
Investing in a debt fund is quite simple. You can invest online in a paperless and hassle-free process.
- You must register on the portal.
- Submit all your details (as asked in the application form).
- Enter the investment details like the amount to be invested and the duration.
- Complete your KYC.
- Invest in the right plan.
Debt mutual funds have high liquidity, a low cost, reasonable security, and stable returns. These are ideal for people who want a regular income but don't like risk. Debt funds are less risky and volatile as compared to equity funds. If you're looking for consistent returns with low volatility while saving on traditional fixed income products such as bank deposits, debt mutual funds are better because they help you reach your financial goals in a more tax-effective manner.