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When companies or entities issuing debt instruments want to raise funds, they ‘borrow’ from investors. In return, they promise a steady and regular interest. This is how debt instruments work in simple terms. We have covered the following in this article:
Buying a debt instrument can be considered as lending money to the entity issuing the instrument. A debt fund invests in fixed-interest generating securities such as corporate bonds, government securities, treasury bills, commercial paper, and other money market instruments. The fundamental reason for investing in debt funds is to earn a steady interest income and capital appreciation. The issuers of debt instruments pre-decide the interest rate you will receive as well as the maturity period. Hence, they are also known as ‘fixed-income’ securities.
Debt funds invest in a variety of securities, based on their credit ratings. A security’s credit rating signifies the risk of default in disbursing the returns that the debt instrument issuer promised. The fund manager of a debt fund ensures that he invests in high rated credit instruments. A higher credit rating means that the entity is more likely to pay interest on the debt security regularly as well as pay back the principal upon maturity.
Debt funds which invest in higher-rated securities are less volatile when compared to low-rated securities. Additionally, maturity also depends on the investment strategy of the fund manager and the overall interest rate regime in the economy. A falling interest rate regime encourages the fund manager to invest in long-term securities. Conversely, a rising interest rate regime encourages him to invest in short-term securities.
Debt funds try to optimise returns by investing across all classes of securities. This allows debt funds to earn decent returns. However, the returns are not guaranteed. Debt fund returns often fall in a predictable range. This makes them safer avenues for conservative investors. They are also suitable for people with both short-term and medium-term investment horizons. Short-term ranges from three months to one year, while medium-term ranges from three years to five years.
Short-term debt funds
For a short-term investor, debt funds like liquid funds may be an ideal investment, compared to keeping your money in a saving bank account. Liquid funds offer higher returns in the range of 7%-9% along with similar kinds of liquidity to meet emergency requirements.
Medium-term debt funds
For a medium-term investor, debt funds like dynamic bond funds are ideal for riding the interest rate volatility. When compared to 5-year bank FDs, debt bond funds offer higher returns. If you are looking to earn a regular income from your investments, then Monthly Income Plans may be a good option. Investing in debt funds is ideal for risk-averse investors as they invest in securities that offer interest at a predefined rate and return the principal invested in full upon maturity.
As mentioned above, there are many types of debt mutual funds, suiting diverse investors. The primary differentiating factor between debt funds is the maturity period of the instruments that they invest in. Following are the different types of debt funds:
Dynamic Bond Funds
As the name suggests, these are ‘dynamic’ funds. Meaning, the fund manager keeps changing portfolio composition as per the fluctuating interest rate regime. Dynamic bond funds have different average maturity periods as these funds take interest rate calls and invest in instruments of longer and as well as shorter maturities.
Income Funds take a call on the interest rates and invest predominantly in debt securities with extended maturities. This makes them more stable than dynamic bond funds. The average maturity of income funds is around five to six years.
Short-Term and Ultra Short-Term Debt Funds
These are debt funds that invest in instruments with shorter maturities, ranging from one year to three years. Short-term funds are ideal for conservative investors as these funds are not affected much by interest rate movements.
Liquid funds invest in debt instruments with a maturity of not more than 91 days. This makes them almost risk-free. Liquid funds have rarely seen negative returns. These funds are better alternatives to savings bank accounts as they provide similar liquidity with higher yields. Many mutual fund companies offer instant redemption on liquid fund investments through unique debit cards.
Gilt Funds invest in only government securities – high-rated securities with very low credit risk. Since the government seldom defaults on the loan it takes in the form of debt instruments; gilt funds are an ideal choice for risk-averse fixed-income investors.
Credit Opportunities Funds
These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds do not invest as per the maturities of debt instruments. These funds try to earn higher returns by taking a call on credit risks or by holding lower-rated bonds that come with higher interest rates. Credit opportunities funds are relatively riskier debt funds.
Fixed Maturity Plans
Fixed maturity plans (FMP) are closed-ended debt funds. These funds also invest in fixed income securities such as corporate bonds and government securities. All FMPs have a fixed horizon for which your money will be locked-in. This horizon can be in months or years. However, you can invest only during the initial offer period. It is like a fixed deposit that can deliver superior, tax-efficient returns but does not guarantee high returns.
Debt funds suffer from 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 probability of default. In interest rate risk, the bond prices may fall due to an increase in the interest rates.
Even though debt funds are fixed-income havens, they don’t offer guaranteed returns. The Net Asset Value (NAV) of a debt fund tends to fall with a rise in the overall interest rates in the economy. Hence, they are suitable for a falling interest rate regime.
Debt fund managers charge a fee to manage your money called an expense ratio. SEBI has mandated the upper limit of expense ratio to be no more than 2.25% of the overall assets. Considering the lower returns generated by debt funds as compared to equity funds, a long-term holding period would help in recovering the money forgone through expense ratio.
If you have a short-term investment horizon of three months to one year, then you may go for liquid funds. Conversely, typical tenures for short-term bond funds can be two years to three years. In case of an intermediate horizon of three to five years, dynamic bond funds would be appropriate. Basically, the longer the horizon, the better the returns.
You can use debt funds as an alternative source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive a pension.
Tax on Returns
Capital gains from debt funds are taxable. The rate of taxation is based on the holding period, i.e., how long you stay invested in a debt fund. A capital gain made during a period of fewer than three years is known as a Short-Term Capital Gain (STCG). A capital gain made over three years or more is known as Long-Term Capital Gains (LTCG). Investors can add STCG from debt funds to his/her income. Here, the tax is as per the income slab. A fixed 20% tax after indexation applies for STCG from debt funds.
Dividends offered by all classes of mutual funds are taxed in the classical manner. They are added to your overall income and taxed at your income tax slab rate. Previously, dividends of up to Rs 10 lakh a year were made tax-free in the hands of investors. The classical way of taxation was introduced in Budget 2020. The rate of taxation of capital gains of debt funds depends on the holding period. If the holding period is shorter than three years, then such gains are called as the short-term capital gains. These gains are taxed at investors’ tax slab. Gains realised after a holding period of three years are termed long-term capital gains. These gains are taxed at 20% after indexation.
Investing in Debt Funds is made paperless and hassle-free at ClearTax. The following steps will help you start your investment journey: