About Debt Mutual Funds
Debt instruments like bonds and debentures are tradeable. For example, a bondholder may sell the bond they hold (including the coupon payments that they are supposed to receive) to a third party in return for a lump sum.
Consequently, mutual fund houses may choose to buy such debt instruments by paying a lump sum now so that they can sell off the debt to another party at a higher price or avail themselves of the regular cash inflow involved in the debt instrument.
Mutual funds that invest most of their corpus in such debt instruments are known as debt mutual funds. There are several debt fund types that investors can choose from, such as low duration funds, money market funds, overnight funds, etc.
How do Debt Funds Work?
Debt mutual funds invest in various types of loans, such as corporate and government bonds, at a specific price and then sell them later at a profit. This profit or loss is what determines the fund's value, known as Net Asset Value (NAV). These funds also earn money through the interest they receive from these loans, which is similar to how you earn interest from a fixed deposit in a bank.
The NAV of a debt fund can change based on a few things.
First, it depends on the interest rates of the loans they own. If interest rates in the market go down, the value of the existing loans they hold goes up, and so does the NAV. If interest rates go up, the NAV can go down.
Second, changes in the credit ratings of the loans they own can also impact the NAV.
So, in simple terms, debt mutual funds aim to make money from interest and the buying/selling of loans, and their value can change based on interest rates and loan ratings.
Features of Debt Funds
- Debt mutual funds generally represent much lower risk but comparatively lower returns than equity funds. This is because there is much higher volatility in stock prices than there is volatility in interest rates and bond prices. That being said, debt is legally required to be paid back - in contrast, there is no legal requirement for a stock price to increase or even fall at a slower pace.
- Debt funds give slightly higher returns but with more risk than Fixed Deposits (FDs). Moreover, unlike FDs, the returns from a debt fund (especially floater funds) may vary with time, depending on the composition of the fund based on maturity and type of debt instrument.
- Usually, debt funds have a stable return rate as they invest largely in fixed-income securities. But they may also have volatile returns if they have significant investments in floating-rate bonds whose returns are benchmarked against volatile interest rates.
Advantages of Investing in Debt Funds
- Liquidity - Many debt funds do not have a lock-in period, allowing the investor to withdraw or cash out their investment whenever they need or want to.
- Tax efficiency - Debt mutual funds are taxed only upon being redeemed, and the tax is only paid on the redemption proceeds, that too after indexation in case of holding for more than 3 years.
- Stability - They offer low-risk, stable returns and can thus help balance a portfolio against changing market conditions by increasing its diversification and tempering the overall risk profile.
- Returns - Debt funds may often have returns much higher than other investment avenues, such as fixed deposits or even singular debt instruments. Sometimes, a retail investor may not be able to give out large loans themselves but may still benefit from large debt instruments by buying small units of a debt fund that owns that debt.
Risks Involved in Debt Mutual Funds
Risks involved in debt mutual funds are more than that in FDs but less than that in equity funds or equity itself. The risk factors can be the following:
- Credit risk - If a large number of the debt instruments are defaulted upon at the same time, especially due to some unforeseen, irreversible event like a recession, a negative business cycle or a disaster, then the debt funds may lose their value very quickly, causing the investors to experience capital losses.
- Interest rate risk - This entails a fall in the bond prices due to a rise in the interest rates of those bonds. This may be caused by a general rise in interest rates by the central bank or a change in the business environment, such as an increase in the demand for money. A fall in the price of bonds makes the resale value of the debt investments of the debt funds fall, causing the overall returns to dip.
Factors To Consider Before Investing in Debt Mutual Funds
When considering investing in debt mutual funds, it's important to keep these factors in mind for a successful investment strategy:
- Investment Goals: First, define your investment objectives. Are you looking for regular income or capital appreciation? Debt funds offer various options, such as liquid funds for short-term needs or long-term income through bond funds. Choose the one aligning with your goals
- Risk Tolerance: Assess your risk tolerance. Debt funds are generally lower risk than equity funds, but they are not entirely risk-free. Evaluate your ability to withstand potential fluctuations in NAV due to interest rate changes or credit risk.
- Investment Horizon: Determine your investment horizon. Debt funds are suited for both short-term and long-term goals, but the choice of fund type may vary based on your time frame. Longer-term investments may allow for more stability.
- Credit Quality: Examine the credit quality of the fund's holdings. Funds with higher-rated bonds are typically safer but may offer lower returns. If you're comfortable with some risk, you can explore funds with lower-rated bonds for potentially higher yields.
- Expense Ratio: Keep an eye on the fund's expense ratio. Lower expense ratios mean more of your returns stay in your pocket. Compare expenses across funds with similar objectives.
- Fund Manager Expertise: Research the fund manager's track record and expertise in managing debt funds. An experienced manager is more likely to make sound investment decisions.
Who Should Invest in Debt Mutual Funds?
Investing in debt mutual funds makes sense for those investors who have a low tolerance to risk profile and want to restrict themselves to debt funds only. Investors looking for a stable anchor investment in order to afford to take on higher risks with their other investments (say in equity, derivatives or even real estate) can also consider these.
If you are a short-term investor, you may choose a liquid fund as then you will not have to sacrifice on liquidity either - you can withdraw your money much more freely. However, if you are a long-term investor, you can choose a fund that could have a lock-in period but give significantly higher returns than fixed deposits.
Taxability of Debt Funds
Debt mutual fund taxation is applicable to both dividends and capital gains received from debt funds.
Dividend taxation - Dividends earned on debt funds are added to the investor's taxable income and taxed at the rate as per the income tax slab. There is also a 10% TDS on dividend amount exceeding Rs. 5000 in a financial year.
Capital gain taxation - Debt funds are taxed only upon redemption, and the tax is paid on the proceeds. However, the exact amount of tax depends on the holding terms.
Debt fund investments are considered to be long-term only after a holding period of 3 years. If the investor withdraws the amount before 3 years, then they will be taxed as per their income tax bracket.
How to Invest in Debt Mutual Funds?
Investing in Debt Funds through your Angel One account is a straightforward process. Follow these simplified steps:
Step 1: Log in to your Angel One account with your registered mobile number, validate the OTP, and enter your MPIN. If you don't have a Demat account, open one by completing the KYC process and submitting required documents.
Step 2: Assess the most suitable debt fund based on your financial goals and risk tolerance. Explore the debt funds available in the Angel One app's mutual fund section. Consider these factors:
- Search for the desired debt fund or choose from Angel One's recommendations.
- Review historical performance, tax implications, sector allocation, and constituent stocks.
- Use the calculator to estimate potential returns.
- Evaluate risk levels and match them with your risk tolerance.
- Refer to reputable rating agencies' ratings, typically ranging from 1 to 5.
- Examine the expense ratio to gauge the cost of investing.
- Decide between lump-sum or monthly SIP investments
- Enter your investment amount and select the preferred payment method, with UPI being the recommended choice.
- For SIPs, set up a hassle-free mandate for future contributions.
Top 5 Debt Funds in India
The following are the top Debt Funds in India:
| Name of the Fund | AUM (₹ Cr) | Expense Ratio | Average YTM | Category YTM | CAGR 3Y | CAGR 5Y |
| Aditya Birla SL Medium Term Plan | 2004.00 | 0.86 | 7.70 | 7.53 | 14.90 | 12.16 |
| Bank of India Credit Risk Fund | 114.41 | 1.03 | 7.04 | 8.18 | 40.15 | 10.74 |
| JM Low Duration Fund | 229.93 | 0.35 | 7.67 | 7.69 | 6.56 | 9.66 |
| UTI Dynamic Bond Fund | 506.98 | 0.69 | 7.09 | 7.11 | 9.49 | 9.61 |
| Aditya Birla SL Credit Risk Fund | 933.02 | 0.67 | 8.26 | 8.18 | 9.75 | 9.21 |
Aditya Birla SL Medium Term Plan
The Aditya Birla SL Medium Term Plan has the highest AUM among the 5 funds, at ₹2,004.00 crore, and an expense ratio of 0.86%.The fund’s average YTM is 7.70%, slightly above the category YTM of 7.53%. Over the past 3 years, it has delivered a CAGR of 14.90%, ranking 2nd in 3-year performance, while its 5-year CAGR of 12.16% is the highest in the list.
Bank of India Credit Risk Fund
The Bank of India Credit Risk Fund has the lowest AUM among the 5 funds, at ₹114.41 crore, and the highest expense ratio of 1.03%.The fund’s average YTM is 7.04%, which is the lowest in the list and below the category YTM of 8.18%. Over the past 3 years, it has delivered a CAGR of 40.15%, the highest among the 5 funds, while its 5-year CAGR of 10.74% ranks 3rd.
JM Low Duration Fund
The JM Low Duration Fund has an AUM of ₹229.93 crore and an expense ratio of 0.35%, which is the lowest in the list.The fund’s average YTM is 7.67%, in line with the category YTM of 7.69%. Over the past 3 years, it has delivered a CAGR of 6.56%, the lowest in the list, while its 5-year CAGR of 9.66% ranks 4th.
UTI Dynamic Bond Fund
The UTI Dynamic Bond Fund has an AUM of ₹506.98 crore and an expense ratio of 0.69%.The fund’s average YTM is 7.09%, close to the category YTM of 7.11%. Over the past 3 years, it has delivered a CAGR of 9.49%, ranking 4th in 3-year performance, while its 5-year CAGR of 9.61% ranks 5th in the list.
Aditya Birla SL Credit Risk Fund
The Aditya Birla SL Credit Risk Fund has an AUM of ₹933.02 crore and an expense ratio of 0.67%.The fund’s average YTM is 8.26%, the highest among the 5 funds, and above the category YTM of 8.18%. Over the past 3 years, it has delivered a CAGR of 9.75%, ranking 3rd in 3-year performance, while its 5-year CAGR of 9.21% ranks 2nd.