1. How do Debt Funds work?
Buying a debt instrument is similar to giving a loan to the issuing entity. The basic reason behind investing in debt funds is to earn interest income and capital appreciation. 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 try to optimize 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. Debt funds invest in different securities based on their credit ratings. A security’s credit rating signifies whether the issuer will default in making the promised payments. 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.
This is why debt funds which invest in higher-rated securities will be less volatile as compared to low-rated securities. Additionally, the 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.
2. Who should Invest in Debt Funds?
Debt mutual funds are ideal investments for conservative investors. They are suitable for both the short-term and medium-term investment horizons
. Short-term starts from 3 months to 1 years. Medium term is from 3 years to 5 years. For a short-term investor, debt funds like liquid funds may be an ideal investment as 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 to ride the interest rate volatility. As compared to 5-year bank FD, these bond funds offer higher returns. If you want to earn regular income from your investments, then Monthly Income Plans may be a good option.
3. Types of Debt 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:
a. Dynamic Bond Funds
As the name suggests, these are ‘dynamic’ funds, which means that the fund manager keeps 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.
b. 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.
c. 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.
d. Liquid Funds
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.
e. Gilt Funds
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.
f. 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.
g. 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.
4. Things to Consider as an Investor
Debt funds suffer from credit risk and interest rate risk which make them riskier than bank FDs. In credit risk, the fund manager may invest in low-credit rated securities which have the 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 funds charge a fee to manage your money called an expense ratio
. Till now SEBI had mandated the upper limit of expense ratio to be 2.25%. Considering the lower returns generated by debt funds as compared to equity funds, a long-term holding period would help in recovering the money gone out by way of the expense ratio.
d. Investment Horizon
You can invest in Debt funds for a range of investment horizons
. If you have a short-term horizon of 3 months to 1 year, you may go for liquid funds. Conversely, short-term bond funds can be considered for a tenure of 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.
e. Financial Goals
Debt funds can be an ideal partner in your portfolio to achieve a variety of goals. You can use debt funds as an alternate source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for purpose of liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive the pension.
f. Tax on Gains
When you invest in debt funds, you earn capital gains which are taxable. The rate of taxation
is based on how long you stay invested in a debt fund called as the holding period. A capital gain made during a period of less 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). STCG from debt funds are also added to the investor’s income and taxed according to his income slab. TCG from debt funds is taxed at the rate of 20% after indexation
5. How to Invest in Debt Funds?
Investing in Debt Funds is made paperless and hassle-free at ClearTax.
Using the following steps, you can start your investment journey:
Sign in at cleartax.in
Enter your personal details regarding the amount of investment and period of investment
Get your e-KYC done in less than 5 minutes
Invest in your favorite debt fund from amongst the hand-picked mutual funds
6. Top 5 Debt Funds in India
While selecting a fund, you need to analyze the fund from different angles. There are various quantitative and qualitative parameters which can be used to arrive at the best debt funds
as per your requirements. Additionally, you need to 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 based on a different investment horizon like 5 years or 10 years returns. You may include other criteria like financial ratios as well.
*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.