Debt market is one of the major markets in India in which people invest their hard-earned money and get returns. The debt market is made of various instruments which simplifies the purchase and sell of loans in exchange for interest. Many investors believes the debt market to be less risky than equity investments. Investors with a lower risk tolerance prefer to invest in debt securities. However, debt investments provide lower returns as compared to equity investments. Here, we will explore what is Debt Funds and will also talk about different types of debt funds along with their benefits and a lot more.
What is a Debt Fund?
Many investor consider buying a debt instrument as lending money to the entity issuing the instrument. Debt funds invest in fixed-interest giving securities such as corporate bonds, government securities, treasury bills, commercial paper, and other money market instruments. The main reason behind investing in debt funds is to earn a steady interest income as well as capital growth. The issuers of debt instruments pre-decide the interest rate which an investor will receive until the maturity period. Hence, they are considered as ‘fixed-income’ securities also.
How do Debt Funds work?
Debt funds invest in various securities, according to their credit ratings. A security’s credit rating indicates the risk of default in receiving the returns that the debt instrument issuer promised. The fund manager of a debt fund ensures that the amount is being invested in the instruments with high credit rating. A higher credit rating means the entity is more likely to pay interest regularly on the debt security and to pay back the principal amount at the time of maturity. Debt funds invest in high-rated securities which are more stable compared to low-rated securities. Additionally, maturity also depends on the investment strategies of the fund manager as well as the interest rate regime in the overall economy. The decreasing interest rate regime encourages the fund manager to invest in long-term securities. Conversely, a better and higher interest rate regime encourages the fund manager to invest in short-term securities.
Benefits of investing in debt funds
Stable income
Debt Funds have potential to provide capital growth over a period of time. If debt funds come with a lower degree of risk than equity funds, the defined returns are not guaranteed and subject to market risks.
Tax efficiency
Many investor invest money with the purpose of reducing their annual income tax. So, if you are the same investor having the goal of tax saving, you can invest in debt mutual funds. Debt funds are more tax-exempt than traditional investment options like fixed deposits (FDs).
The interest earned on your FD is taxable every year irrespective of the maturity date. If you invest in debt funds, you have to pay tax only in the year you redeem. You have to pay tax only on the redemption proceeds, whether it is a partial redemption or full redemption. You are eligible for Short Term Capital Gains (STCG) tax if you hold your mutual fund units for less than 3 years and Long-Term Capital Gains (LTCG) for investments more than 3 years. LTCG are eligible for indexation benefits wherein you pay tax only on the returns which are above the inflation rate (cost inflation index {CII}). This reduces your tax liability and also provides better returns post tax.
High liquidity
Fixed deposits have a pre-defined lock-in period. If you decide to exit from your FD before maturity, you may have to pay a penalty. Debt mutual funds don't have any lock-in periods. Some of the funds have an exit load which is a charge deducted at source for early withdrawals. The exit load period is different for every fund while some funds have zero exit load as well. However, debt mutual funds are liquid and allow you to withdraw your money from the fund on any business day.
Stability
Debt funds can provide you stable returns and increase the balance of your portfolio. Equity funds (while offering higher return potential) can be volatile and they are linked directly to the performance of the stock market. By investing in debt funds, you can easily diversify your portfolio and reduce the overall risk.
Flexibility
Debt mutual funds also provide an option of moving your money to different funds. which can be done through a Systematic Transfer Plan (STP). Debt funds provide the option to invest a lump sum amount and systematically transfer a small portion of the amount into equity at regular intervals. Thus, you can easily spread out the risk of equities over a specified period of a few months rather than investing the entire amount at one point. Other traditional investment options do not provide such degree of flexibility to investors.
Types of Debt Funds
Following are the different types of debt funds:
Dynamic Bond Funds
As the name indicates, these are ‘dynamic’ funds. Meaning, the fund manager keeps changing portfolio composition according to the fluctuating interest rate regime. Dynamic bond funds have different average maturity periods because these funds take interest rate calls and invest in instruments of longer and shorter maturities.
Income Funds
Income Funds take a call on the interest rates and invest predominantly in debt securities with extended maturities which makes them more stable than dynamic bond funds. The average maturity period of income funds is 5 to 6 years.
Short-Term and Ultra Short-Term Debt Funds
These debt funds invest in instruments with shorter maturities with the period of one year to three years. Short-term funds are ideal for traditional investors as these funds are not affected much by the movements of interest rate.
Liquid Funds
Liquid funds invest in debt instruments which have a maturity period of less than 91 days. Thus, liquid funds becomes almost risk-free have rarely seen negative returns. These funds are considered as better than savings bank accounts as they provide similar liquidity with higher yields. Many mutual fund companies provide instant redemption on liquid fund investments through unique debit cards.
Gilt Funds
Gilt Funds invest only in government securities which are high-rated with very low credit risk. Since the government almost never defaults on the loan it takes in the form of debt instruments; gilt funds are an ideal choice for risk-averse investors and they are a good source of fixed-income.
Credit Opportunities Funds
Credit opportunities funds do not invest in debt instruments according to the maturity period. These funds takes risk, try to earn higher returns by taking a call on credit risks or buy lower-rated bonds that come with higher interest rates. Credit opportunities funds are comparatively riskier debt funds.
Fixed Maturity Plans
Fixed maturity plans (FMP) are closed-ended debt funds which also invest in fixed income securities like corporate bonds and government securities. All FMPs have a pre-determined horizon for which your money will be locked-in. This horizon can be in months or years. You are allowed to invest in FMPs only during the initial offer period. FMPs are like a fixed deposit that can deliver superior and tax-free returns but does not guarantee high returns.
Tax on Gains
Dividends given by all the mutual funds are taxable in the classical manner. They are added to your overall income and are taxable at your income tax slab rate. Previously, dividends of up to Rs 10 lakh per year were tax-free in the hands of investors. The classical way of taxation was introduced in the Budget of FY 2020. The tax rate of capital gains earned on debt funds depends upon the holding period. If the holding period is less than three years, then such gains are considered as the short-term capital gains which are taxed at investors’ tax slab. Gains earned on the holding period of more than three years are considered long-term capital gains which are taxed at 20% after indexation.
Points to remember while investing in Debt Mutual Funds
Risk
Debt funds have credit risk and interest rate risk, which makes them riskier than bank FDs. In credit risk, the fund manager may invest in low-credit rated securities which have a higher chances of default. In interest rate risk, the bond prices may decrease due to an increase in the interest rates.
Return
Even though debt funds are considered as a fixed-income sources, they don’t offer guaranteed returns. The Net Asset Value (NAV) of a debt fund tends to fall if the overall interest rates rise in the economy. Hence, they are likely for a falling interest rate regime.
Cost
Debt fund managers charge a fee to manage your money which is called an expense ratio. SEBI has mandated the upper limit of expense ratio to be no more than 2.25% of the overall funds. Considering the lower returns made by debt funds as compared to equity funds, a long-term holding period would help in recovering the money gone through an expense ratio.
Investment Horizon
If you have a short-term investment horizon of three months to one year, then you can invest in liquid funds. Opposite to it, typical tenures for short-term bond funds can be two to three years. Dynamic bond funds would be appropriate an intermediate horizon of three to five years. Basically, the longer the horizon, the better returns you can expect.
Financial Goals
You can invest in debt funds to make a source of income apart from your salary. Additionally, new investors can invest some portion of their amount in debt funds for liquidity. Retirees may invest the large portion of retirement benefits in a debt fund to receive a regular pension.
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