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What is a Debt Fund- A Comprehensive Guide
Debt instruments are issued by companies or entities raising funds by borrowing from investors. They pay a steady and regular interest in return. Debt is the major market where people readily invest for a passive income source. It is also less risky than equity investments, making it a wise option for investors having a lower risk tolerance. However, the returns may also be lower as compared to equity investments. As a potential investor, you must know everything about debt funds before getting into this zone. We have a comprehensive guide explaining the ins and outs of this investment option.
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What is a Debt Fund?
A debt fund essentially invests in fixed-interest-generating securities like government securities, corporate bonds, commercial paper, treasury bills, and other money market instruments. Asset management companies (AMCs) manage these funds for investors looking for a stable and predictable source of income. As an investor, you can expect a steady interest income along with capital appreciation with this form of investment.
The issuers pre-decide the interest rate and the maturity period for debt funds, making them ‘fixed-income’ securities. Additionally, you get the benefit of diversification across a range of debt instruments, mitigating risks. The best part is the liquidity of these funds, enabling investors to buy and sell units easily. Taxation on these instruments depends on the holding period.
How do Debt Funds work?
Debt funds invest in diverse securities based on their credit ratings. Every debt security has a credit rating. It signifies enabling the possibility of default by the issuer in disbursing the principal and interest. A higher rating implies fewer chances to default. As an investor, you can understand this as a risk factor. Debt fund managers consider these ratings to assess debt instruments and select high-quality options.
Debt funds investing in higher-rated securities are less volatile than low-rated securities. Additionally, maturity depends on the interest rate regime in the economy and the investment strategy of the fund manager. A falling interest rate regime is a cue for the fund manager to invest in long-term securities. On the other hand, a rising interest rate regime prompts an investment in short-term securities.
Types of Debt Funds
The best approach to debt funds investment entails building a diverse and versatile portfolio with minimal risk and maximum returns. Here are the options you can explore:
Dynamic Bond Funds
Dynamic funds refer to the changing portfolio composition according to the fluctuating interest rate regime. Your fund manager picks options with different average maturity periods, from shorter to longer timelines.
Income Funds
With these funds, your manager will invest predominantly in options with extended maturities, making them more stable than dynamic alternatives. The average maturity is around five to six years.
Short-Term/Ultra Short-Term Debt Funds
These funds have shorter maturity periods, ranging from one to three years. They are apt for conservative investors as interest rate movements hardly affect them.
Liquid Funds
With liquid funds, you get instruments with a maturity period of less than 91 days, making them almost risk-free. The option rarely leads to negative returns. Like savings bank accounts, they provide high levels of liquidity. But the plus is that you get higher yields with them. Mutual fund companies have instant redemption on these through unique debit cards.
Credit Opportunities Funds
Credit opportunity funds do not hinge on the maturities of debt instruments. Instead, they take a call on credit risks. Alternatively, they can be in the form of lower-rated bonds with higher interest rates. These are relatively new and have riskier debt funds.
Gilt Funds
Gilt funds invest only in government securities. These are high-rated alternatives with very low credit risk because the government seldom defaults on the loan it borrows in the form of debt instruments. This option is the best for risk-averse fixed-income investors.
Fixed Maturity Plans
Fixed maturity plans invest in fixed-income securities like government securities and corporate bonds. They have a fixed horizon for which investor money will be locked in. It may be for months or years.
However, an investor can invest only during the initial offer period. Like a fixed deposit, they deliver superior, tax-efficient returns but do not guarantee high yields.
Floater Funds
With floater funds, at least 65% of assets are invested in floating-rate bonds. They have less risk because coupons on their floating-rate holdings are reset periodically according to market rates.
Who should invest in Debt Funds?
Factors such as financial goals and risk tolerance determine whether you should invest in debt funds. They are regarded apt for the following:
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You have short-term goals such as buying a car or saving for a vacation
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You want to earn higher interest than conventional fixed-income instruments by taking some moderate level of risk
Besides short-term investors (investing for three months to one year), medium-term investors may consider term fund investments for three to five years. Liquid funds are suitable for short-term investors because they offer higher returns than a savings bank account and a similar kind of liquidity to meet emergencies. Medium-term investors must pick dynamic bond funds to ride the interest rate volatility.
What is the Tax Treatment for Gains from Debt Funds?
Dividends from mutual funds are taxed conventionally. Basically, you have to add them to your income, and they are taxed at your tax slab rate. Before 2020, annual dividends of up to Rs 10 lakh were tax-free in the hands of investors. However, Budget 2020 introduced the classical way of taxation on these gains.
The rate of taxation of capital gains depends on the holding period. For a holding period shorter than three years, these gains are called short-term capital gains and are taxed at investors’ tax slabs. Long-term capital gains are realised after a holding period of three years and are taxed at 20% after indexation.
Benefits of Investing in Debt Funds
Debt funds offer a range of benefits over conventional investments such as bank deposits. These include:
Debt funds offer a range of benefits over conventional investments such as bank deposits. These include:
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Investors get the opportunity to earn interest and capital gains from debt. They can also access money markets they cannot directly invest in. The best part is that professional expertise comes as a part of the deal.
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Since debt funds are relatively less risky than equity counterparts, a strategic allocation lowers risk and brings stability to the investment portfolio. Tactical investments can help investors make the most of temporary yield opportunities.
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Debt funds are available in a broad range of options in terms of maturity and credit risk. While short-duration funds are ideal for regular and stable income, longer-duration funds are apt for high income and capital gains.
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Debt funds are liquid, so they can be redeemed as easily as within one or two working days. Unlike fixed deposits or recurring deposits, they have no lock-in period. A few funds may have a small exit load for early withdrawal, but generally there are no penalties.
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They are low-cost investments as the SEBI guidelines limit the total expense ratio of a debt fund only to 2% of Assets under Management.
Factors to Consider as an Investor
As a potential investor, you must consider the following factors while assessing a debt fund.
Risk
The credit risk and interest rate risk of debt funds make them riskier than bank FDs. You must check these factors when investing in debt funds.
Return
Debt funds do not offer guaranteed returns. When the overall interest rates in the economy rise, their Net Asset Value (NAV) tends to fall. They are more apt for a falling interest rate regime.
Cost
Since fund managers charge a fee to manage debt funds, cost is another key factor. This expense ratio is limited by a SEBI mandate.
Financial Goals
Debt funds may work as an alternative income source to supplement your regular income. Additionally, budding investors can invest in them for liquidity. Retirees may invest their retirement benefits in these funds to receive a pension for stability.
Investment Horizon
Your investment horizon is another factor in determining the choice of debt funds. For example, choose liquid funds for a short-term investment horizon (three months to one year). Long-term investment horizon makes dynamic bond funds more appropriate. A longer horizon translates into better returns.
Tax on Returns
Since capital gains from debt funds are taxable, you must consider this factor as well. The taxation rate is based on the holding period. Capital gain for less than three years is Short-Term Capital Gain (STCG), while a longer holding leads to Long-Term Capital Gains (LTCG). You must add STCG from debt funds to your income. A fixed 20% tax is after indexation applicable to STCG from debt funds.
Popular Debt Funds in India
Frequently asked questions
Q
How do debt funds work?
A
Debt funds essentially invest in fixed-interest instruments like government and corporate bonds and other debt instruments. It makes money from interest and price appreciation of the securities they are invested in
Q
Who invests in debt funds?
A
Debt funds are appropriate for conservative investors seeking higher interest than regular FDSs. They are also ideal for those with an investment horizon of 1-3 years. You can consider them to diversify your investment portfolios. They balance the risk from equity investments with stability. Overall, the suitability of debt funds for an investor depends on the individual goals and risk tolerance.
Q
Are debt funds safer than FD?
A
Both forms of investments have different risk profiles. While FDs are safer due to their deposit insurance and fixed interest, debt funds may have some element of risk with credit risk and interest rate risk.
Q
What are a few examples of debt funds?
A
Examples of debt funds include government bonds, corporate bonds, corporate debt securities, and money market instruments.
Q
Are debt funds tax-free?
A
No, debt funds are not tax-free. They are taxed according to your income tax slab.
Prachi Jain
Chartered Accountant
Prachi Jain is a Chartered Accountant with a passion for simplifying finance and tax-related matters through her insightful and informative blogs. With a background in finance and a deep understanding of tax regulations, Prachi has established herself as a trusted source of financial wisdom. Prachi is committed to empowering her readers with the knowledge they need to make informed financial decisions. Her expertise and dedication shine through in every blog post, helping her audience navigate the intricacies of finance and taxes with confidence. Follow Prachi Jain's blog for practical insights and guidance on managing your finances effectively.
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