When a company or issuing entity wants to raise funds, they sometimes ‘borrow’ from investors. In return, they promise a steady and regular interest to the lender. This is how a debt fund works. In this article, let us explore debt funds in detail.
Buying a debt instrument is similar to giving a loan to the issuing entity. A debt fund invests in fixed-interest generating securities like corporate bonds, government securities, treasury bills, commercial paper and other money market instruments. The fundamental reason for investing in debt funds is to earn interest income and capital appreciation. The issuer pre-decides 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 different securities, based on their credit ratings. A security’s credit rating signifies whether the issuer will default in disbursing the returns they promised. The fund manager of a debt fund ensures that he invests in high credit quality 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 amount upon maturity.
Debt funds which invest in higher-rated securities are less volatile when compared to that of 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 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 optimize returns by diversifying across different types of securities. This allows debt funds to earn decent returns. However, there is no guarantee of returns. 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 3 months to 1 year, while medium-term ranges from 3 years to 5 years.
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 kind of liquidity for meeting emergency requirements.
For a medium-term investor, debt funds like dynamic bond funds can be 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 the Monthly Income Plans may be a good option.
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 they invest in. Here are the different types of debt funds:
As the name suggests, these are ‘dynamic’ funds. Meaning, the fund manager keeps changing portfolio composition according to fluctuating interest rate regime. Dynamic bond funds have a different average maturity period as these funds take interest rate calls and invest in instruments of longer 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 5-6 years.
These are debt funds that invest in instruments with shorter maturities, ranging from 1 to 3 years. Short-term funds are ideal for conservative investors as these funds are not 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. Rarely have liquid funds seen negative returns. These funds are better alternatives to savings bank accounts as they provide similar liquidity with higher returns. Many mutual fund companies offer instant redemption on liquid fund investments through unique debt 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.
These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds do not invest according to 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 (FMP) are closed-ended debt funds. These funds also invest in fixed income securities like 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. Until now, SEBI had 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 fund as compared to equity funds, a long-term holding period would help in recovering the money lost through expense ratio.
If you have a short-term investment horizon of 3 months to 1 year, you may go for liquid funds. Conversely, ideal tenures for short-term bond funds can be 2 to 3 years. In case of an intermediate horizon of 3 to 5 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.
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 3 years is known as a Short-term Capital Gain (STCG). A capital gain made over a period of 3 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.
Investing in Debt Funds is made paperless and hassle-free at ClearTax. Using the following steps, you can start your investment journey:
There are various quantitative and qualitative parameters to determine the best debt funds as per your requirements. Additionally, it would be best if you keep your financial goals, risk appetite and investment horizon in mind. The following table represents the top 5 debt funds in India, based on the past 1 year returns. Investors may choose the funds with different investment horizon like 5 years or 10 years returns. You may include other criteria like financial ratios as well.
Debt Fund Name
*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.