Investing in debt funds ensures low-risk income against market exposure involved with equity investment. The issuer pays pre-decided interest, payable at maturity. Hence, these are also called fixed-income investments.
What are Debt Funds?
When companies or the government need money, they raise it from the market in forms of bonds. So, when you purchase bonds, you are actually lending money to these entities. Debt funds are types of mutual funds that invest in fixed-income generating debt instruments.
Debt funds are great investment products, especially for investors with a low-risk appetite, who want to generate a steady stream of income from their investment. If you have been saving in traditional saving instruments like FD or savings account, debt mutual funds are better options as it helps you get better returns.
How Does The Debt Funds Work?
Debt funds invest in a variety of fixed income securities like bonds and treasury bills, including gilt funds, and various monthly income plans, short term plans, and fixed maturity plans. A debt fund manager selects from the sea of debt plans available in the market that offer the highest return and carry high credit rating.
Credit rating refers to the rating given to various debt instruments by the credit rating agencies that signifies the issuer’s risk of default to pay back the debt. A higher rating means higher credibility. The fund manager invests in funds that carry the highest rating to ensure regular interest payment and maturity. Debt funds investing in higher rating debt instruments are less volatile and attractive to fund managers and investors alike.
Debt fund managers devise their investment strategies to generate a robust return for the investors, which prompts them to select long-term debt plans when interest rates are falling, and short term plans when it is high.
Types Of Debt Funds
There are several types of debt mutual funds available for investment. Based on maturity and the instruments they invest in, debt funds are of the following classes.
Dynamic Bond Funds
It is dynamic because the portfolio composition keeps changing to adjust to the changing interest regime. Dynamic bond funds have different maturity since they invest in both long-term and short-term debt instruments depending on the interest rate.
Dynamic debt funds suit investors with moderate risk appetite with an investment horizon of 3-5 years.
liquid fund MFs invest in bonds with a maximum maturity of 91 days. These bonds offer a better return than traditional savings accounts over a short time.
Money Market Funds
These debt mutual funds invest in different money market instruments with a maximum maturity of one year, suitable for investors with a short-term investment plan.
Corporate Bond Funds
These funds invest up to 80 percent of the corpus into various corporate bonds with the highest rating to generate a higher return. These are good instruments for investors with low-risk tolerance.
As the name implies, income funds aim to generate income over a long term. Therefore, invest in long term bonds and debt instruments. Income funds have an average tenure of five to six years, making them more stable than dynamic bonds.
Short-term and Ultra Short-Term Funds
These funds have an average maturity of one to three years. These funds generate a stable return for investors seeking low-risk return for short-term.
Gilt funds invest in government-backed securities with a very high rating and low credit risk. Since a government will seldom default, these funds attract risk-averse investors who seek fixed-return on investment.
Banking and PSU Funds
Fund managers allot at least 80 percent of the corpus in different banking and PSU sector companies generating a steady, low-risk return on investment.
Credit Risk Funds
In credit risk funds, around 65 percent of the corpus gets allocated to less pristine credit rating funds, hence they carry a higher risk than other debt mutual funds but also generate a better return.
Fund managers allocate around 65 percent of the corpus to various floating rate instruments. In the scale measuring risks of debt funds, these are low-risk investments.
Fixed Maturity Plans
Fixed-maturity plans come with a lock-in period. You invest in these plans for a specific duration and receive a fixed return on maturity. These funds invest in various corporate and government bonds, which are low-risk.
The above list contains a broad classification of debt funds. But apart from these, there are several other combinations of debt mutual funds available for investment. We suggest you get clarity on the available options before investing in the best one.
Advantages Of Debt Funds
There are multiple advantages to investing in debt funds.
- Debt funds are the best for investors with low risk-appetite who want a steady and assured return
- Adds stability to your portfolio as well helps in diversification to ensure a balanced return in all market condition
- No deduction of TDS or taxes. Taxes apply if an investor sells or withdraw fund units, depending on the length of the investment period
- Debt funds generate a better return than traditional savings plans like Fixed Deposit
- Offer cost advantages to investors as the charges are low compared to other mutual fund investments
Debt mutual funds have evolved and modernised to offer a wide range of short and medium-term investment opportunities.
Short-term debt funds
Liquid funds offer both liquidity and higher return for short-term investors. These funds have generated an average of 7 to 9 percent return.
Medium-term debt funds
Investors looking at an investment horizon of three to five years can choose dynamic debt funds to invest in. These funds are designed to ride interest rate volatility to generate a healthy return on investment.
Investors looking to create an alternative source of income can choose debt funds that are Monthly Income Plans (MIPs).
Things To Consider
Here are a few things to consider regarding investing in debt mutual funds.
Debt funds are low risk, but they are still riskier than fixed deposits in banks. These funds invest in various debt instruments in the market, hence, carry an inherent risk associated with market volatility and interest rate regime.
The net asset value (NAV) of the investment will impact your return from these funds.
To invest in debt mutual funds, you have to pay an expense ratio. SEBI has fixed the upper limit for the same at 2.5 percent.
Debt funds come with various maturity periods and even lock-in periods. Investors would need to select plans that suit their financial goal.
Capital gains from debt funds are subject to capital gain tax. Short-term capital gain is charged on investment for less than three years.
Return on debt funds depends on two factors – future interest rate and the price of the bonds. The price of bond instruments depends on economic conditions. When the economy is booming, companies can spend more to cater to the rising demand side. It fuels demand for funds, and companies borrow more, resulting in rising interest rates as demand for credit rises. On the contrary, in a contracting economy, demand for credit goes down as consumers start to spend less. The excess of credit then actually lowers the interest rate. To revive the economy and encourage businesses to avail loans, the government also reduces the lending rate, causing the price of debt instruments to shoot up.
Since bond price moves in the opposite direction of the interest rate, a higher long tenure bond requires little funds invested in short tenure bonds, which causes the current rate to fall. Investors begin to anticipate the rates to decline further in the future, which causes the current rates to increase. A similar situation occurred when the pandemic ravaged the nation’s economy last year. But surprisingly, debt mutual funds yielded in the negative, which left many of the investors baffled.
During August 2020, most debt funds produced negative returns as sinking GDP and lowered GST collection, along with rising inflation, put pressure on its yield. Foreign portfolio investors were selling heavily in both the debt and money markets, and there was increasing pressure from domestic investors to withdraw from the mutual funds amid rising uncertainties. The supply of funds in the economy also shrunk as banks were trying to keep their NPA low. It reduced the availability of cash in the market. Collectively these factors created a negative situation for the debt funds and impacted the NAV value, which fluctuates daily based on market movements.
Remedies offered by the RBI
Whenever the Indian economy had struggled to find a foothold, RBI, as the central bank, came to the rescue. It was no different in the current scenario. RBI came to the rescue of debt fund investors by purchasing government securities from the market, which increased cash flow in the economy. It also trimmed repo and reverse repo rates to ease the pressure from the banks. Lower interest rates attracted borrowers and normalised the liquidity crunch created by the pandemic. Side-by-side, RBI also increased the supply of the US dollar into the foreign exchange market to strengthen the Indian rupee.
It introduced LTRO or Long-term Repo Operations to encourage banks to invest in bonds and commercial papers to boost the demand for these products. These impacted debt mutual funds and improved NAV.
When interest rates come down in the market, investors start putting their money in the debt fund. But as the economic uncertainties rise, it impacts the creditworthiness of the borrowers. Investors can safeguard their capital by investing in government securities, banking and PSU funds, and corporate bond funds as these are relatively safe since the chances of default are minimal.
Lastly, select a fund based on your risk appetite and investment horizon. If the investment need is immediate you can put the funds in overnight funds or a liquid fund over long-term investment funds.