While equity mutual funds invest in shares of publicly listed companies, debt funds invest in fixed-income securities issued by the government and companies. These fixed income securities include corporate bonds, government securities, treasury bills, money market instruments and other such debt securities.
Investing in an equity instrument like a stock is like buying ownership into that company to participate in its growth. But when you buy a debt instrument, you give a loan to the issuing entity. The government and private companies issue bills and bonds to get a loan to use to run their operations.
The interest that you earn on these debt securities is pre-decided along with the duration after which the debt security will mature. That’s why these securities are called ‘fixed-income’ securities, because you know what you’re going to get out of them.
Debt funds, just like equity funds, try to optimise returns by diversifying across different types of securities. This allows debt funds to earn decent returns, but there is no guarantee of returns. However, debt fund returns can be expected in a predictable range, which makes them safer avenues for conservative investors.
Different types of securities that debt funds invest in
Debt funds invest in different securities that have different credit ratings. A security’s credit rating signifies the risk associated with the entity that is issuing the security.
A higher credit rating means that the entity is more likely to pay interest on the debt security as well as pay back the principal amount upon maturity. This is why debt funds which invest in higher-rated securities will be less volatile as compared to low-rated securities.
Another factor that determines the kind of securities that debt funds invest in is the maturity of that security. Different types of debt funds invest in securities that mature after different time periods. The shorter the maturity period, lesser will be the volatility of the debt security.
Types of debt mutual funds
Just like equity mutual funds, debt mutual funds are also of various types. The primary differentiating factor between debt funds is the maturity period of the instruments they invest in.
Here are the different types of debt funds:
Dynamic bond funds
As the name suggests, these are ‘dynamic’ funds, which means that they keep changing portfolio composition according to changing interest rate regime.
Dynamic bond funds have a fluctuating average maturity period because these funds take interest rate calls and invest in instruments of longer as well as shorter maturities.
Income funds can also take a call on interest rates and invest in debt securities with different maturities, but most often, income funds invest in securities that have long maturities. This makes them more stable than dynamic bond funds. The average maturity of income funds is around 5-6 years.
Short-term and ultra short-term debt funds
These are debt funds that invest in instruments with shorter maturities, which range from around a year to 3 years. Short-term funds are ideal for conservative investors as these funds are not majorly affected 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 seen negative returns very rarely.
These funds are good alternatives to savings bank accounts as they provide similar liquidity and higher returns. Many mutual fund companies offer instant redemption on liquid fund investments through special debt cards.
Gilt funds invest in only government securities. Government securities are high-rated securities and come with a very low credit risk. It’s because the government seldom defaults on the loan it takes in the form of debt instruments. This makes gilt funds ideal for risk-averse fixed income investors.
Credit opportunities funds
These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds don’t invest according to the maturities of debt instruments.
These funds try to earn higher returns by taking a call on credit risks. These funds try to hold 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-end debt funds. These funds also invest in fixed income securities like corporate bonds and government securities, but they come with a lock-in.
All FMPs have a fixed horizon for which your money will be locked-in. This horizon can be in months or years. Investments in FMPs can be made only during the initial offer period. An FMP is like a fixed deposit that can deliver superior, tax-efficient returns but do not guarantee returns.
How do interest rates affect debt funds?
Interest rates that we often hear about in the news are the repo rate and reverse repo rates, are decided by the Reserve Bank of India (RBI). The RBI lends money to the commercial banks at the repo rate.
There are a lot of factors that result in the increase or decrease of interest rates, but the prevailing interest rates also determine the rate at which institutions issue bonds and other debt securities.
The prices of fixed income securities are inversely proportional to interest rates. With an increase in interest rates, bond prices go down. And vice versa. This is why debt funds tend to earn higher returns when interest rates fall or are expected to fall, as the prices of bonds will go up.
Who should invest in debt funds?
Debt mutual funds are ideal investments for conservative investors. They are good alternatives to fixed deposits. While debt funds deliver returns that are in the range of fixed deposit interest rates, they are more tax-efficient than fixed deposits.
The interest income earned from fixed deposits are added to your income and taxed as per the slab you fall under. Short-term gains from debt funds are also added to the investor’s taxable income. But they become tax-efficient when the holding period is 3 years or more. The long-term gains are taxed at 20% after indexation.
Debt funds are also liquid when compared to fixed deposits. While fixed deposits come with a lock-in period, debt funds can be redeemed any time. Partial redemption can also be done from debt funds.
It is for these reasons that debt funds are recommended in place of fixed deposits. However, one point to keep in mind is that unlike fixed deposits, debt funds don’t guarantee capital protection or fixed returns.