All About Debt Funds – Meaning, Types, and the Best Debt Funds
When a company or entity issues debt funds, it wants to raise money, so debt funds are a way to borrow money from investors. In return, companies provide stable, secure, and regular interest payments in the form of returns. This is a simple explanation of how debt security works.
What Is Debt Mutual Fund?
When you invest in a debt mutual fund, it simply means that you are lending money to the issuer of the securities. Debt funds mean investing in fixed-income securities such as corporate or government bonds, commercial projects, treasury bills, or other money market instruments.
Investing in debt funds mainly minimises risks and gets stable interest income and capital appreciation. Therefore, they are also called "fixed-income" securities.
How Do Debt Mutual Funds Work?
Debt mutual funds invest in various securities based on creditworthiness. The managers of debt funds ensure that your investment is made in quality credit products where the company is more likely to pay interest on its debt regularly and repay the principal when it is due. Debt funds that invest in well-established companies are less volatile.
Thus the risk factor is minimal. In addition, the returns you can expect from debt funds depend on your fund manager's investment strategy and the prevailing interest rate. Falling interest rates encourage fund managers to invest in long-term securities and vice versa.
Who Should Invest in Debt Funds?
Debt funds are for those investors who have a low-risk appetite. It is for people who expect a decent return but not as high as the returns of equity funds (which also come with high risks). You should be aware that debt funds are often predictable, which makes them a safer bet. It is most suitable for people who are looking for short-term (3 months – 1 year) and medium-term (3 years- 5 years) investments.
Rather than keeping your money in a savings account, where the interest rate is low, you can invest your money in debt funds. Debt funds offer higher yields in the 7% to 9% range and similar liquidity to meet urgent needs. These are also ideal for offsetting interest rate fluctuations.
What Are the Best Debt Mutual Funds to Invest In?
Debt mutual funds invest primarily in fixed-income instruments such as Treasury bills and certificates of deposit. The primary objective of these funds is to generate long-term wealth in the form of interest income and steadily increase the value of the capital invested. The underlying asset generates a fixed interest rate over the period the investor continues to invest in the fund.
How Do You Rate The Best Debt Mutual Funds?
Debt fund managers invest primarily in assets based on their credit ratings. A higher credit rating of a debt fund means it is more likely to repay the principal at the end of the investment period and pay interest periodically.
Fund managers also align their investment strategies with interest rate trends. Here are some factors that will help you rate the best debt mutual funds:
Returns and Risks
Suppose you are looking for long-term debt fund investment returns such as 3, 5, or 10 years, select funds that consistently outperform benchmark and comparison funds over various periods.
You must also analyse the fund's performance, yield, and returns that match your investment period to get results. However, the past returns of the debt fund do not guarantee future returns.
Fund History
Choose a fund company with a long history of consistent investment performance of at least 5-10 years.
Expense Ratio
This is the charge you pay to manage the debt mutual fund. Investing in funds with lower expense ratios is better, as this means better returns because of low costs.
Other Financial Statistics
You can analyse your funds using financial metrics such as standard deviation, Sharpe ratio, alpha, and beta. Funds with high standard deviation and high beta carry more risk than funds with low beta and low standard deviation. Look for funds with higher Sharpe ratios. This means that each additional unit of risk yields a higher return.
About Debt Mutual Fund Taxation
Before January 2020, the fund house was liable to pay the DDT - dividend distribution tax before it paid out the dividends to the investors. As an investor, you did not have to pay any taxes on the returns.
But this changed after the 2020 Federal Budget. Dividends earned from debt mutual funds are now taxed traditionally. This means that the earnings or returns from debt funds will be considered a part of the gross income and taxed according to the applicable income tax schedule.
Selling the Debt Fund's shares within the three-year holding period provides short-term capital gains. These profits are added to gross income and taxed according to the applicable income tax schedule. Selling shares in a debt fund provides long-term capital gains after a three-year holding period. These profits are taxed at 20% after indexing.
Risks Associated With Debt Funds
Debt funds are subject to the following risks:
- Interest rate risk, which is the volatility in the rates of underlying securities of the debt mutual fund plan
- Credit risk if the company/entity is not able to meet its obligations to repay the principal on time and to pay interest regularly
- Liquidity risk if the mutual fund company does not have sufficient liquidity to meet the redemption demands.
Types Of Debt Mutual Funds
Investors can choose from different debt funds depending on their maturity, risk profile, and investment objectives.
- Overnight funds that are of short duration with a maturity of 1 day.
- Liquid Debt funds that invest in bonds and money market securities for up to 91 days.
- Ultra-short-term funds that invest in bonds and the money market for 3-6 months.
- Low Duration funds that invest in fixed income and money market instruments in the range of 6-12 months.
- Money Market Debt mutual funds that invest in money market paper for up to one year.
- Short-term funds that invest in fixed income for 1-3 years.
- Medium-term Debt funds invest in fixed-income portfolios for 3 to 4 years.
- Corporate Bond funds invest primarily in corporate bonds rated AA+ or higher.
- Credit Risk funds that invest primarily in securities rated AA or below (excluding AA+ corporate bonds).
- Bank and PSU Debt mutual funds that invest a minimum of 80% of their assets in bonds and commercial papers issued by banks, PSUs (public corporations), public financial institutions, and municipalities.
- Dynamic Bond funds invest in bonds of various maturities based on current interest rates.
- Gilt funds invest at least 80% of their assets in government bonds of various maturities and are perfect for risk-averse investors.
Advantages Of Debt Mutual Funds
Below are some of the main benefits of investing in debt funds.
Insensitive To Market Movements
Debt funds are hugely unaffected by market movements which means they are less volatile. A debt fund's portfolio consists primarily of fixed-income securities, and the returns are much more stable because the fund invests in fixed-income securities. Therefore, risk-averse investors or new investors should consider investing in these funds.
Best Way To Store Surplus Funds
When you have surplus funds, you can think of traditional investing methods, like bank deposits, or you could invest in debt mutual funds. The risk is low compared to equity funds, and the returns are higher compared to a regular savings account.
Bring Stability and Liquidity to Investment Portfolio
Debt funds are highly liquid and can easily be turned into cash in a day. These investment funds also help fund houses stabilise their portfolios and diversify their mutual funds.
Better Returns
These funds offer higher returns than bank deposits and come with lower transaction costs than other mutual funds.
Professional Management
Professional fund managers manage investments in these funds, which invest in bonds with the highest yields compared to a certain level of risk that retail investors may not find easy.
Systematic Investment
While traditional investments must be made in bulk, investing in debt funds can be the SIP, facilitating long-term wealth accumulation.
Conclusion
Investing in debt funds means investing in fixed-income instruments that have low risk and generate capital growth. Debt funds are also called income funds or retirement funds.
Debt funds generally have stable returns, high liquidity, and reasonable security. If you are a risk-aversive or a new investor, who wants to try investing in the mutual fund market, then Debt funds are an excellent alternative to reach your financial goals.
Frequently Asked Questions
Are debt funds affected by market volatility?
Debt funds are less risky than equity funds but are still subject to market volatility which relies on the average duration of each portfolio. The longer the average maturity, the greater the short-term uncertainty and the higher the volatility.
Conversely, the shorter the average maturity, the higher the security and the lower the volatility. To get the most out of your debt fund, it's important to match your investment horizon to the life expectancy of your debt fund scheme.
Is there a block-in or lock-in period for debt mutual funds?
There are various kinds of debt mutual funds, and they don't have any lock-in period. You can redeem your investments subject to applicable exit fees.
Who should invest in debt funds?
Debt mutual funds are an excellent investment for:
- First-time investors
- Investors who have been depending on RDs and FDs for returns
- Investors with a low-risk tolerance
- Investors who want to generate regular income in short to medium term
Are Debt funds Risk-Free?
Debt funds are not entirely risk-free but carry a lower risk than equity funds. Debt funds carry risks related to liquidity, credit, and interest rates. But these risks emerge if you invest in debt mutual funds with poor credit ratings.
Which are the best debt mutual funds?
There is no definition of the best debt mutual funds, as it entirely depends on your risk tolerance, financial objectives, and investment portfolio. Naturally, investing more for a longer period will generate higher returns and vice versa.