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Debt mutual funds are a category of mutual funds that invest in debt and money market instruments. Money market and debt market instruments include commercial papers, certificates of deposits, treasury bills, non-convertible debentures, government bonds, G-Secs, among others.
The primary objective of debt or money market instruments is getting income in the form of interest payments. Some debt funds also generate capital appreciation for investors. Debt funds generate returns by investing in bonds and fixed-income securities. It is important for investors to include debt mutual funds in their portfolio as debt funds help diversify the portfolio and also protect the portfolio from the volatility of the stock market.
Investors can invest in debt mutual funds through SIP or lump sum investment, however some debt mutual fund schemes (like fixed maturity plans) cannot be routed through the SIP method.
Debt mutual funds can be used to park money for a day or to remain invested for over longer horizons. In general, it is advisable to use debt funds for a time horizon which is less than five years. The type of debt funds to choose from depends on the investor’s financial goals, risk appetite and duration of investment. Debt mutual funds offer low to moderate risk, high liquidity, and allows investors to hedge against market volatility. Investment in debt mutual funds have the potential to offer higher returns compared to bank deposits.
Risks Involved in Debt Mutual Funds
It is important for investors to select the right debt mutual funds according to their risk appetite, investment tenure and investment goals. It is vital for investors to understand the risk factors involved in debt mutual funds:
- Interest rate risks: Debt mutual funds are inversely proportional to interest rate changes. If interest rate decreases, returns of debt mutual funds increase and vice-versa.
- Credit risk: A credit risk is the risk on debt security that arises when an issuer fails to make payment. Various credit agencies like Crisil and care assign a credit rating to bonds. If the credit rating of an instrument degrades, the price falls and vice-versa.
Interest rate risk is for a shorter duration only as a period of falling interest rates is often followed by a period of rising interest rates. Therefore, if investors have a longer time horizon, the volatility due to interest rate changes could be overcome. But, if an issuer defaults on payments then the price of the instrument falls permanently. Credit risk is permanent and investors should minimize this risk.
Categories of Debt Funds
Debt mutual funds have comparatively lower risks to equity funds. Debt funds are categorized into different categories depending on the maturity period.
- Overnight funds invest in instruments which mature overnight and have no interest rate risk. Liquid funds invest in securities with mature time less than 91 days.
- Ultra-short and low duration funds have a duration in the range of 3 to 12 months and have low to moderately low interest rate risk.
- Short duration funds range between one to three years and have moderate interest rate sensitivity.
- Medium to long duration, long duration and gilt funds’ durations range from four to seven years are comparatively more sensitive to interest rate.
Who Should Invest in Debt Funds
Debt funds are ideal for investors who want stable returns and have low to moderate risk appetite.
- Debt funds are intended to improve the stability of the portfolio as debt funds help against volatility due to market movements.
- Debt mutual funds diversify the portfolio across various securities to ensure stable returns.
- The investment in debt mutual funds can help the investors in accomplishing their financial goals in a tax efficient manner thereby yielding good returns.
- Investments in debt mutual funds can be redeemed anytime as per the investors requirements.
Taxation of Debt Funds
The rate of taxation depends on the investors’ holding period. If an investor invests in debt mutual funds for more than three years, the investment qualifies for long term capital gain tax with indexation benefit.
However, if investors invest for less than three years, then the gains are added to the income and taxed as per the tax slab.
Advantages of Debt Mutual Funds
Below are the benefits of investing in debt mutual funds:
1. Stability and diversification
The funds are invested in fixed income securities and the returns from these investments are stable compared to equity mutual funds. Investors with a low to moderate risk appetite should consider investing in debt mutual funds. The diversification of the portfolio due to debt funds help stabilize investment returns.
Debt mutual funds might yield lower returns than other investments, but returns would be more stable and regular.
2. Hedge against volatility
Debt mutual funds could be a great option to hedge against volatility. Debt funds carry lower risk and are less volatile than other forms of market-linked instruments such as equity funds. By incorporating debt mutual funds in their portfolio, investors can manage the risk involved during volatile market conditions.
3. Higher liquidity
Debt mutual funds are an alternative to bank fixed deposits. Investment in fixed deposits involves a lock-in period and tedious withdrawal process. Investors can enjoy the benefits of extremely liquid investment by investing in debt mutual funds. Investors can withdraw the investments as per their requirement and the amount will be credited in the bank account within a day.
4. Lower transaction costs
Debt funds have lower transaction costs compared to equity and other mutual funds. Debt funds do not incur TDS. However, debt mutual funds are taxed on the basis of holding period, classified as short-term capital gains or long-term capital gains.
Bottom Line
It is important to choose debt mutual funds based on one’s investment horizon. Careful consideration must be given while choosing different schemes based on one’s goals and liabilities. There are a variety of debt mutual funds to choose from which can meet requirements of investors. Investors should also note that debt funds are not entirely risk free since they are market linked and should consider all factors before investing in debt mutual funds.
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Saurav BasuContributor
Saurav heads the wealth management business at Tata Capital. He has more than 20 years of experience in the financial services sector. Prior to joining Tata Capital, he worked with Citibank and Philips India. Saurav is an alumnus of Indian Institute of Management, Lucknow and National Institute of Technology, Suratkal.
Aashika JainEditor
Aashika is the India Editor for Forbes Advisor. Her 15-year business and finance journalism stint has led her to report, write, edit and lead teams covering public investing, private investing and personal investing both in India and overseas. She has previously worked at CNBC-TV18, Thomson Reuters, The Economic Times and Entrepreneur.
