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Debt Mutual Funds

Debt are loved by many investors, as they are less risky than equity mutual funds, and are often seen as an alternative to bank savings accounts and fixed deposits. They bring safety and stability to an investor's portfolio. Understanding everything about debt mutual funds will help you know whether you should add them to your portfolio and what other options you can consider instead of them.
In this article, we will learn what debt mutual funds are, how they work, what are the benefits of investing in them, what are factors you should consider before investing in them, and more. We hope this article will help you make informed investment decisions.

What Are Debt Mutual Funds?

Debt mutual funds are mutual fund schemes that invest predominantly in fixed income-generating securities like Commercial Papers (CP), Certificates of Deposit (CD), Corporate Bonds, T-Bills, government securities, and other money market instruments. These instruments have a fixed maturity date and interest rate, which the buyers could earn until the maturity of the security. Debt mutual funds are considered to be less volatile than equity funds.
There are different types of debt funds and they are Overnight Funds, Liquid Funds, Ultra-Short Duration Funds, Money Market Funds, Short-Duration Funds, Medium Duration Funds, Corporate Bond Funds, Credit Risk Funds, Banking & PSU (Public Sector Undertaking) Funds, Dynamic Bond Fund, Gilt Funds, Fixed Maturity Plans.

How Do Debt Mutual Funds Work?

Debt mutual funds are a type of mutual fund that generate returns from their investors' money by investing in bonds or deposits of various kinds. In simple words, they lend money and earn interest on the money they have lent. This interest that they earn forms the basis for the returns that debt funds generate for investors.
Debt funds invest in many types of bonds such as bonds issued by many large and medium-sized businesses in the country. That's why it is possible to easily diversify fixed-income investments via debt mutual funds. Just like shares, these bonds are also tradeable. The prices of different bonds can rise or decline because of several factors.
But due to fluctuation, a mutual fund can make additional over and above what it would have made out of the interest income alone if it buys a bond and its price subsequently increases. This would result in a higher return for investors.

What Are The Types Of Debt Mutual Funds?

There are different types of debt mutual funds that are available for investors to choose from. The features of these low-risk funds differ according to their type.

Overnight Funds

This mutual fund invests in those securities that have a maturity period of 1 day. These funds carry minimal credit risk and interest rate risk due to the short maturity period. Therefore, overnight funds are said to be relatively stable.

Liquid Funds

This mutual fund invests in debt and money market securities with a maturity period of not more than 91 days. Investors can withdraw up to ₹50,000 as an instant redemption facility from some liquid funds.

Ultra-Short Duration Funds

This fund invests in debt securities and money market instruments such that the *Macaulay Duration of the portfolio is between 3 to 6 months.
*Macaulay Duration - It is the length of time taken by the investor to recover his invested money in the bond through coupons and principal repayment. This length of time is the weighted average of the period the investor should remain invested in the security to have the present value of the cash flows from the investment match the amount paid off the bond.

Money Market Funds

This debt mutual fund invests in money market securities with a maximum maturity of 1 year.

Short Duration Funds

This mutual fund invests in debt securities and money market instruments such that the Macaulay Duration of the portfolio is between 1 to 3 years.

Medium Duration Funds

This debt mutual fund invests in debt securities and money market instruments such that the Macaulay Duration of the portfolio is between 3 to 4 years.

Corporate Bond Funds

This fund invests predominantly invests in corporate bonds rated AA+ and above.

Credit Risk Funds

This debt mutual fund predominantly invests in papers rated AA and below (excluding AA+ rated corporate bonds). This fund invests in papers that offer relatively higher interest rates. On the other hand, these funds carry credit risk compared to other debt funds.

Banking & PSU (Public Sector Undertaking) Funds

This debt mutual fund invests at least 80% of its assets in debt and money market securities of Banks, PSU, Public Financial Institutions, and Municipal Bodies.

Dynamic Bond Funds

These funds invest in debt instruments that have shorter (1 to 3 years) as well as longer (3 to 5 years maturities). The fund manager will change the portfolio depending upon their forecast of interest rates. If the forecast is for increasing interest rates, the maturity is shorter and if the forecast is for falling interest rates, the maturity is longer. These funds are slightly riskier than short-term debt funds.

Gilt Funds

These debt funds invest at least 80% of their assets in government securities with varying maturities. These funds have exposure to sovereign papers, which carry very little credit risk. Hence, they are considered relatively stable investments.

Fixed Maturity Plans

FMPs come with a lock-in period, which can differ based on the scheme you choose. You can invest in FMPs only during the initial offer period, and post that, you cannot make further investments in this scheme. FMPs are compared to FDs often as they come with a lock-in period. However, FMPs don't promise fixed returns, unlike FDs. But, FMPs are more tax-efficient than FDs.

Who Should Opt For Debt Mutual Funds?

Here are a few types of investors who can consider investing in debt mutual funds.
Newbie Investors - If you are someone who has never invested in mutual funds before, you can consider investing in debt mutual funds as the risks associated are lower. Also, debt mutual funds offer more stability compared to equity mutual funds. If you are moving from traditional investment instruments to mutual funds, debt mutual funds will be a good option as they attempt to generate better returns than traditional instruments.
Investors Who Invest Only In Equity - Some investors invest mostly in equity instruments and they stay invested for the long term. If you are one of them, you should consider allocating some portion of your income towards debt mutual funds, as they are ideal for the short term. Debt mutual funds can offer a suitable diversification in your portfolio.
Experienced Investors - If you have invested for a while, you may need debt funds in your portfolio to balance the risks associated with equity or other categories such as gold, real estate, etc. Debt funds can bring stability to your portfolio and you can also put your lumpsum money in reserve in debt mutual funds before you start a systematic transfer plan (STP) to your equity mutual funds.
Risk-Averse Investors - If you are someone who doesn't want to take any major risks with your money, you can consider debt mutual funds as a suitable option. You can choose them for your short-term goals such as buying a car, a new gadget, and so on.
Senior Citizens - It is often advised that senior citizens should opt for low-risk, fixed-income instruments. So, debt mutual funds are perfect for old investors.

How Can You Invest In Debt Mutual Funds?

There are two investment modes through which an investor can invest in mutual fund schemes. They are
Lumpsum - You choose lump sum if you wish to invest one time in a mutual fund scheme. Usually, people choose this method when they receive a bonus, so they can put the money in a scheme as a one-time investment.
If you wish to know how much and how long you need to invest to achieve your goals, please check the Lumpsum Calculator, created by Koshex.
Systematic Investment Plan (SIP) - You choose SIP when you want to invest a fixed amount in a scheme at regular intervals. You can choose to invest ₹5000 every month or ₹10,000 every quarter. When the due date comes, your amount will be deducted automatically from your bank account and it will be used to purchase units of the mutual fund scheme.
If you wish to know how much you need to invest every month via SIP to achieve your goals, please check the SIP Calculator, created by Koshex.

What Are The Benefits Of Investing In Debt Mutual Funds?

There are several benefits to investing in debt mutual funds. Below we have mentioned a few of them.

Diversification

When you invest a certain portion of your assets in debt funds, it will help protect your portfolio from the volatility of equity investments.

Risk Management

Investments in debt funds lower the risk of losses as they are less volatile as compared to stocks and equity mutual funds.

Opportunity To Earn Regular Income

Debt mutual funds help in generating regular income through a dividend distribution. Depending upon the type of debt fund, you can get dividends daily, weekly, fortnightly, monthly, semi-annually, or annually.

Advantage Of Interest Rates

If an investor selects the right type of fund that is suitable for his risk appetite and investment horizon, they may be able to generate income in line with the prevailing rates of interest.

Opportunity To Park Surplus Funds

Equity mutual funds have proven to be very volatile in the short term. However, debt funds offer the opportunity to retail investors to park their surplus for a short while and earn good returns on them.

What Are The Factors You Should Consider Before Investing In Debt Mutual Funds?

Here are some of the factors that you must consider before investing in a debt mutual fund.

Past Performance

If you are looking to invest in a debt mutual fund that has been around for a while, make sure you are checking the fund's performance record. Even though past performance doesn't guarantee future returns, it can act as a good indicator of how the Asset Management Company (AMC) has managed the investor's money until now.

Interest Rate Risk

Debt mutual funds are sensitive to changes in interest rates because they invest in the bond market. During a falling interest rate period, existing debt mutual funds see capital appreciation as previously issued bonds have a higher coupon rate. On the other hand, in a rising interest rate period, newly issued bonds and securities offer better coupon rates, affecting the performance of the debt funds. Hence, checking the current interest rate period is a crucial factor in the selection of debt mutual funds.

Credit Risk Of Portfolio

Before you invest in any debt mutual fund, it is important to check the portfolio's asset allocation. It is important to know the credit ratings of the portfolio constituents. So, before you select a debt mutual fund, you should check the securities and choose a fund that invests in bonds whose creditworthiness matches your risk appetite.

Duration & Maturity

The NAV (Net Asset Value) of a debt mutual fund is affected by the interest rate. This affects the average maturity and duration of a fund. Typically, debt funds that mature after a longer duration are more volatile and perform better in a falling interest rate regime. Shorter duration debt funds perform better even in rising interest rate regimes. Hence, it is crucial to check the average maturity and modified duration of all debt funds for maximizing your returns.

Yield To Maturity

YTM denotes that income in the event that all the portfolio constituents of the debt mutual fund are held until maturity. However, YTM alone can't help you make the right choice but when you deduct the expense ratio for the gross YTM projected by a debt fund, you can get a fair estimate of its potential return.

Expense Ratio

The expense ratio is the amount of investment that goes into managing the funds. An investor should carefully consider the expense ratio as it can have a direct impact on the returns generated by the fund. If the expense ratio is low, the returns would be high, and vice versa.

What Is The Taxation On Debt Mutual Funds?

Debt mutual funds are subject to capital gains tax.
Short Term Capital Gains (STCG) Tax
If the debt mutual funds are held for less than three years, then it will be classified as short-term capital gains. STCG for debt mutual funds are taxed as per the individual's tax slab.
Long Term Captial Gains (LTCG) Tax
If the debt fund is sold after three years, it is known as long-term capital gains. The current tax rate for LTCG is 20% with indexation.

In The End…

Debt mutual funds are a good investment option if you are looking to earn stable returns with less risks. They are a perfect investment instrument for newbies, investors who are looking to diversify their portfolios, and senior citizens who are looking for stable returns. There are many types of debt mutual funds so you can choose the one that suits your investment horizon and investment goals.
We hope this article helped you understand all about debt mutual funds and how they can help you earn higher returns on your extra money. It is important to learn how debt mutual funds will benefit you and what factors you should consider before investing in them.
If you wish to learn more about other types of mutual funds, including ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, and Smart Deposits, head over to our Blogs section. You can also check out our Calculators, where you can learn more about how much wealth you can accrue in certain years.
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FAQs

Which is better - PPF or debt mutual fund?
Choosing between a Public Provident Fund (PPF) and a debt mutual fund depends on your financial goals, risk tolerance, and investment horizon. Here are a few points you should consider before choosing the right investment instrument for you.
  • If you want to earn guaranteed returns, you can go for PPF.
  • For short-term goals, you can consider debt mutual funds and for long-term goals (15 years or more), you can go for PPF.
  • If you wish to save taxes, you should go for PPF.
  • If you need the flexibility to access your funds and earn stable returns, you can consider debt mutual funds.
Is it safe to invest in debt mutual funds?
Yes. Debt mutual funds are safer than equity mutual funds since they don’t invest in equities. Debt funds carry low risk and are suitable for earning stable returns. However, debt funds still carry risks like credit risk, interest rate risk, inflation risk, etc.
When should I exit debt mutual funds?
You can exit your investment in debt mutual funds
  • If the fund has accumulated enough corpus to help achieve your goal
  • If the fund has been underperforming for a long while
  • If your asset allocation has changed.
Are debt funds risk-free?
No. Debt funds are not completely free of risks. Even though they are safer when compared to equity mutual funds, they still carry risks like credit risk, interest rate risk, inflation risk, etc.
How do I choose a debt fund?
Here is a mini guide to choosing the right debt fund for you.
  • Assess your financial goals and see which one will help you achieve them.
  • Be aware of current market trends, economic trends, and regulatory changes to see if they are affecting the performance of debt funds
  • Debt funds provide a range of risk profiles from conservative to aggressive. So, choose a fund that suits your risk appetite.
  • Decide on an investment horizon so that you can choose from various funds like liquid funds, short-duration funds, dynamic bond funds, and so on.
  • Learn in which direction the interest rates are going so that you can choose a proper fund and make a profit out of that.
  • Ensure that your personal investment goals align with the fund's objectives.
  • Always choose a fund with a diversified portfolio.