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ELSS vs Debt Funds: A discussion around the merits of investing in ELSS, debt funds, and a combination of the two

19 July 20236 mins read by Angel One
ELSS vs Debt Funds: A discussion around the merits of investing in ELSS, debt funds, and a combination of the two
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Vishnu is a 40-year-old IT professional who invested in fixed deposits and a few insurance products through most of his early adult life. Given the current situation of low returns on fixed deposits, he has been pondering about investment in mutual funds for potentially better returns that could multiply his wealth. Being a novice about mutual funds, he discussed with his banker friend, Avinash who firmly vouched for mutual funds as a better investment option. Avinash then probed the depth of knowledge Vishnu has on mutual funds and found that he was faced with a dilemma on the selection between equity vs debt funds. Based on Vishnu’s investment goals- higher education expenses for his son in 4 years from now and accumulation of a corpus for post-retirement which is 15 years away, Avinash advised a debt fund for a 4-year, short term goal, and an equity fund for a long-term post-retirement corpus.

What is a Debt Mutual Fund?

Debt Mutual Funds invest in fixed-income securities like government and corporate bonds, treasury bills, and several other money market instruments with a pre-decided maturity date and an interest rate that a buyer or fund house earns on maturity. Debt fund investments are usually considered low risk since they are not market-linked.

Who can invest in debt funds?

Investors with a low-risk appetite may invest in debt funds as the money gets distributed across various securities ensuring decent and stable returns. Also, debt funds are an ideal choice for short-term (3-12 months) investors and medium-term (3-5 years) investors who expect better returns in comparison to FDs.

Types of Debt Funds

There are numerous types of debt funds tailored to match the choices of diverse investor profiles. Most debt funds are categorised based on the maturity period of securities invested. Here are a few types of debt funds based on their maturity period:

  • Liquid Funds: These funds invest in instruments with a maturity period of upto a maximum of 91 days. These funds usually can potentially offer better returns than a savings account and are considered to be least risky.
  • Dynamic Bond Funds: These invest in debt instruments with varying maturities and are sought by investors with moderate risk tolerance and an investment period of 3 to 5 years.
  • Corporate Bond Funds: These invest a minimum of 80 percent of its total assets in corporate bondswith the highest ratings. These are suitable for investors with a low-risk appetite but looking to invest in high-quality corporate bonds.
  • Gilt Funds: These invest a minimum of 80 percent of its total assets in government securities with varying maturities. They are accompanied by high-interestrate risk.
  • Credit Opportunities Funds: One of the most recent typesof debt funds, these funds function irrespective of the maturity period, and earn relatively better returns by deciding on credit risks or by holding low-rated bonds that entail higher interest rates. These are relatively less risky debt funds.

Merits of Debt Funds

  • Steady Income: Debt funds can potentially appreciate the capital invested over a periodenabling a stable income. They come with a relatively low degree of risk as compared to equities and are not subjected to market risks.
  • High Liquidity: Debt mutual funds do not come with a lock-in period but attract an exit load charge upon early redemption of the fund money. The exit load charges vary from fund to fund and may also be NIL in the case of some debt funds. So, debt funds are highly liquid and can be redeemed on any given business day.
  • Balanced Portfolio: Investing in debt funds shall increase the stability of an investment portfolio. They diversify the portfolio and adequately balance the risks caused by investment in market-linked equity funds.
  • Flexibility: Money invested in debt funds can be moved around to different funds through a Systematic Transfer Plan (STP) option. This option allows a portion of the lump sum amount invested in debt funds to be transferred into equities at regular intervals. This way, the risk of equities can be evenly spread over a specified period.

What are ELSS Funds?

ELSS funds are equity-linked saving schemes that come with a lock-in period of three years and the money invested in these funds is eligible for tax exemption upto an amount of Rs. 1.5 lakhs from yearly taxable income under Section 80C of the Indian Income Tax Act. The returns are market-linked and if the income earned post the lock-in period exceeds Rs. 1 lakh, a long-term capital gains (LTCG) of 10 percent is applicable on this income.

Who can invest in ELSS funds?

ELSS funds are an ideal option for salaried individuals who are looking for a higher yield and yet wish to claim tax benefits under section 80C of the Indian Income Tax Act. Additionally, ELSS funds could be a safe option for first-time investors who generally fear equity investments due to their higher degree of risk. The risk associated with equity investments gradually reduces in the long-run and the lock-in period of ELSS funds helps balance the risks.

Merits of ELSS Funds

  • Hassle-free Investment: Money can be invested easily and regularly in ELSS funds through a monthly SIP without burdening your finances.
  • Potentially HigherYield: As these are market-linked schemes, the returns are potentially higher on an investment ranging from medium-term to long-term.
  • Shortest Lock-in: ELSS has a shorter lock-in period of 3 yearsas compared to other tax-saving instruments like the five-year lock-in for FD or a 15-year lock-in on PPF.
  • Post-Tax Returns: LTCG from ELSS funds are tax-freefor upto an amount of Rs. 1 lakh. A 10 percent LTCG is applicable for an amount above Rs. 1 lakh. Lower tax rates and higher returns ensure better post-tax returns

Given the respective merits of debt funds and equity funds, the dilemma of equity vs debt funds always persists. Worry not, you do not have to choose between the two anymore, as Hybrid or Balanced Funds are here to your aid.

What are Balanced Funds?

Balanced or Hybrid funds invest in a combination of debt and equity funds in a specified ratio, enabling investors to diversify their portfolio. These funds not only ensure capital appreciation but also provide safety against potential risks. It is a suitable option for investors looking out for a combination of income, capital appreciation, and a low-risk investment.

Merits of Balanced Funds

Risk minimisation: In Hybrid funds, the debt instruments minimize the risks posed by the equity instruments caused due to market volatility.

Fund re-balancing: During times when the equity market is overvalued over the debt market or vice-versa, the hybrid funds allow the investors to move between asset classes.

Portfolio diversification: Balanced funds are a great option to diversify an investment portfolio in optimizing returns as well as providing a safety net against market risks.

Tax Benefits: These funds protect the investor from a tax liability while switching between debt and equity instruments. If investors were to do it directly, it would have attracted taxation under capital gains.

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