What are Debt Funds? | Meaning and Benefits

Debt fund mutual fund schemes invest in fixed income producing assets such commercial papers (CP), certificates of deposit (CD), corporate bonds, Treasury Bills (T-Bills), government securities, and other money market instruments. These financial instruments have a set maturity date and interest rate that buyers can receive up to the security’s maturity. They are thought to be less erratic than equities funds, making them the perfect choice for those who are opposed to risk and seek consistency in their investments.

How debt funds operate?

Based on the credit ratings of the securities, debt funds invest in a range of securities. The risk of not receiving the returns that the issuer of the debt instrument promised is indicated by a security’s credit rating. A debt fund’s fund management makes care to invest in highly rated credit instruments. With a better credit rating, the firm is more likely to make timely interest payments on the debt security as well as principal repayments when they are due.

Compared to low-rated assets, debt funds that invest in higher-rated securities are less volatile. Additionally, maturity is influenced by the fund manager’s investment strategy and the general interest rate environment in the economy. The fund manager is encouraged to invest in long-term securities by a regime of declining interest rates. On the other hand, a regime of rising interest rates stimulates him to make investments in short-term assets.

Who should invest in a debt fund?

Debt mutual funds can be the suitable investment choice for someone in one of the following groups.

• Getting started in the world of investing, and you are unsure of how to set up an investment
• Trying to find a low-risk, short-term
• Searching for a financial product that offers a somewhat higher return than a savings account or a fixed
• Want to put money into fixed-income securities with a fixed interest rate and regular interest
• Already has a reliable source of income and is searching for additional monthly

Different debt funds

Debt mutual funds come in a variety of forms that may accommodate a wide range of investors, as was already noted. The maturity term of the securities they invest in is the main distinction between debt funds. The many categories of debt funds are as follows:

• Income Funds: These Funds make interest rate decisions and invest mostly in debt instruments with long maturities. They become more stable as a result, unlike dynamic bond Income funds typically have a maturity of five to six years.
• Debt funds with a short and ultra-short maturity :These debt funds invest in securities with shorter maturities, often between one and three Because they are less impacted by changes in interest rates, short-term funds are perfect for conservative investors.
• Dynamic Bond Funds: These are “dynamic” funds, as the name implies. In other words, the portfolio composition is always changing to reflect the interest rate regime. Due to interest rate calls and investments in securities with both longer and shorter maturities, dynamic bond funds have varying average maturity
• Gilt Funds exclusively invest in highly rated, very low credit risk government For risk-averse fixed-income investors, gilt funds are the perfect option because the government seldom defaults on the loans it receives in the form of debt instruments.
• Liquid Funds Investments made by liquid funds are made in debt securities with a maximum 91-day maturity. As a result, they are nearly risk-free. Negative returns have been uncommon for liquid funds. Since these funds offer comparable liquidity and greater rates than savings accounts, they are preferable alternatives. Through special debit cards, several mutual fund providers allow quick redemption on investments in liquid
• Credit Opportunities Funds: These debt funds are fairly new. Credit opportunities funds do not make investments based on the maturities of the debt instruments, in contrast to other debt funds. These funds seek to increase returns by betting on credit risks or owning bonds with lower ratings but higher interest rates. Debt funds with higher risk levels include credit opportunities

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Benefits of debt fund investing

A variety of advantages come with investing in debt mutual funds. Below are some of the most significant advantages:

Independent from the equity market

Mutual funds that invest in debt are unaffected by stock market turbulence. Your investment in debt funds is not vulnerable to the type of volatility that equity markets experience.

High liquidity

Unlike the majority of other investment products, such as fixed deposits, which have statutory lock-in periods and incur penalties for early withdrawal, debt funds can be liquidated simply and you may cash out of your investment considerably faster. Therefore, please consider debt funds if you believe you might want more cash in the event of a personal or medical emergency or if you wish to set aside additional funds for a short time.

Lower Costs

Compared to equities and other mutual funds, debt funds charge lower transaction fees. FDs, which most investors also regard to be low-risk investments, do not incur TDS, but debt and other mutual fund schemes do. If you sell fund units, however, you will be required to pay taxes based on the term of investment. When compared to fixed deposits or your savings account, they often give higher returns.

Risk factors

It’s vital to keep in mind that, unlike bank deposits, debt mutual funds (MFs) do carry some risk. Your investment could be impacted, for example, by a change in interest rates. Unexpected events may cause the corporation in whose bond your fund may have invested to fail. A liquidity crisis, on the other hand, would definitely put your investment at danger. Since the returns on debt are likely to be far lower over the long run than those of the equity market, debt funds are a smart choice if you want to be cautious and have a set financial goal and deadline in mind. Alternatively, if you have extra money in your savings account that might earn more interest from loans.

Debt fund risks

Fundamentally, three categories of risk exist for debt funds:

Credit risk is the possibility that the issuer won’t make the principle and interest payments as agreed.

Interest Rate Risk refers to the impact of shifting interest rates on the securities of the plan.

Liquidity risk is the chance that the fund house won’t have enough cash on hand to fulfil redemption requests.

Indexation and taxes on debt mutual funds

The fact that the income generated by debt funds is subject to indexation is one of the main benefits of debt mutual funds. By changing the underlying debt instrument’s acquisition price, indexation lowers your overall tax burden. Inflation and investment capital gains are taken into account to achieve this.

Debt fund capital gains are taxed. How long you continue to invest in a debt fund determines the tax rate. Short-term capital gains (STCG) are capital gains achieved in less than three years, whereas long-term capital gains (LTCG) are those made in more than three years (LTCG).

Long-term capital funds are taxed at a rate of 20% after indexation, whereas short-term capital gains are taxed according to the investor’s income tax bracket.

Relevance to individual investors

Debt fund investors are often stockholders who seek to diversify their holdings. Similar to a stock ETF, debt funds often perform differently from equity funds. Bond prices may not decline as much, or they may even increase, if stock prices decline on a certain day. This is why mixing debt and equity funds makes your account’s worth less prone to ups and downs.

Debt funds are also used by investors as a risk protection for the overall investment portfolio. For someone with a portfolio which is heavily tilted towards equity, adding a percentage of debt funds to the portfolio reduces the overall volatility and minimises the overall risk of the portfolio.

Some individuals purchase debt funds to supplement their retirement income. Investors will get interest from the mutual fund or ETF’s holdings of bonds. Debt funds usually distribute dividends on a quarterly basis, which also include any interest payments made during the quarter. Other debt funds distribute monthly dividends in the form of interest payments.

 

About the Author

Ketan Sonalkar (SEBI Rgn No INA000011255)

Ketan Sonalkar is a certified SEBI registered investment advisor and head of research at Univest. He is one of the finest financial trainers, with a track record of having trained more than 2000 people in offline and online models. He serves as a consultant advisor to leading fintech and financial data firms. He has over 15 years of working experience in the finance field. He runs Advisory Services for Direct Equities and Personal Finance Transformation.

Note – This channel is for educational and training purpose only & any stock mentioned here should not be taken as a tip/recommendation/advice

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