Debt Funds - Meaning, Types, Advantages
The popularity of debt mutual funds has been rising steadily in India. They offer superior returns than bank fixed deposits plus are tax-efficient. But before you join the bandwagon and start investing in debt funds, you must know exactly what are debt funds, how debt funds work, their types, advantages and how to invest in debt mutual funds.
In this article we cover
1) What are Debt Mutual Funds?
2) Why Should You Invest in Debt Funds?
3) Who Should Invest in Debt Mutual Funds?
4) Types of Debt Mutual Funds in India
5) Things to Consider Before Investing in Debt Mutual Funds
6) How are Debt Funds Taxed?
7) How To Invest in Debt Mutual Funds?
What are Debt Mutual Funds?
We already know that all mutual funds are an investment vehicle that collect money from various investors. This money is then invested in different assets as per their investment objectives.
Mutual funds that invest the pooled money in ‘debt instruments’ are known as Debt mutual funds. Debt funds invest in fixed income securities such as:
- Treasury Bills (T-Bills)
- Certificate of Deposits (CDs)
- Commercial Papers (CPs)
- Corporate Bonds
- Government Securities (G-secs)
- Money Market Instruments
Basically debt mutual funds invest in ‘Debt’. A debt is a loan. In debt funds, investors are the lenders while private, public companies and the government are the borrowers. Investors give loans to these corporates in exchange for ‘fixed income securities’.
These securities have a fixed maturity date and fixed interest rate. Hence debt funds are also referred to as fixed income funds.
The primary reason behind the popularity of debt funds is that they offer higher returns than bank deposits. Additionally, these returns are ‘fixed’ in nature. Hence, debt mutual funds are safer than equity mutual funds.
Why Should You Invest in Debt Funds? - Advantages of Debt Mutual Funds
Debt mutual funds offer the following benefits to investors:
High Returns: Debt mutual funds have consistently generated higher returns than bank fixed deposits. The below chart shows the returns generated by different debt fund categories in the last 10 years.
* Average 1-Year Returns
High Liquidity:Majority of debt mutual funds do not have a lock-in period. This means that you can redeem from debt funds anytime. Additionally, the redemption from debt funds is received in T+1 Days. T stands for transaction date. So, if you redeemed from your debt fund on 1st January, you will receive the proceeds on 2nd January.
But debt funds like Fixed Maturity Plans (FMPs) and close-ended debt funds cannot be sold before their fixed maturity date.
Low Risk: When you invest in debt funds, the fund manager takes the pooled money and gives loans to companies and the government. While investing in debt securities, fund managers try to invest in companies with high credit ratings.
A high credit rating (AAA) means the fund is highly stable and carries low-risk. Corporate debt funds have a mandate to invest 80% of their corpus in ‘AAA’ rated debt papers only.
Diversification: Debt mutual funds are a great tool to hedge against the risks in your equity portfolio. As asset classes, debt and equity have an inverse relationship. During stock market volatility investors shift from equity funds to debt funds for higher stability. This move helps investors earn higher returns (than bank deposits) while avoiding the market volatility.
Perfect for all-kinds of Investment Horizon: Debt mutual funds have a diverse range of investment options. There is a debt fund for every type of investment horizon.
- Liquid funds are perfect for short-term financial goals.
- Gilt funds or long-term debt funds are great for long-term financial goals.
- Investors with a medium-term investment horizon can invest in dynamic bond funds.
So, debt funds are suitable for all kinds of investment horizons.
Access to the Fixed Income Market: Debt funds have given retail investors a chance to participate in the Indian fixed income market. This market was always dominated by banks, insurance companies, hedge funds etc. This was because retail investors did not have sufficient capital to participate in the fixed income market. But by pooling their funds together, debt fund investors have been able to access the massive Indian fixed income market and invest in bonds offering higher returns.
Superior Tax-Adjusted Returns: Debt mutual funds offer tax benefits in the form of indexation if you sell your debt fund after 3 years. Indexation increases your purchase price. This in turn reduces your profit and tax payable.
This facility is not available in bank deposits. Plus in bank deposits, TDS is deducted. No TDS is deducted in case of debt mutual funds.
Convenience & Affordability: Investing in debt mutual funds is not restricted to the rich. Debt funds are highly convenient as you can either invest in one go (lumpsum investing) or invest small amounts every month via a systematic investment plan (SIP). Investors can start investing in debt funds with as little as Rs 500 via the SIP route.
Who Should Invest in Debt Mutual Funds?
Many believe that only conservative or low-risk investors should invest in debt funds but this is a wrong assumption. The universe of debt funds is so huge that there are certain debt funds which are suitable to only high risk investors. These include credit risk debt funds, 10-year gilt funds etc.
Ideally every investor must invest a portion of their portfolio in debt funds. This helps them manage the volatility of the stock market. The exact proportion of debt in the portfolio is dependent on the investors risk tolerance and financial goals.
- Low-risk investors with short-term financial goals can invest upto 70%-80% in debt funds.
- Moderately risky investors with short-term financial goals can invest upto 50% in debt funds.
- Aggressive investors with short-term financial goals can invest 20%-30% in debt funds.
Debt funds are also great for investors who are building an emergency fund, also known as a contingency fund. Every investor must set aside 6 months of mandatory expenses for emergencies. This fund should be easily accessible and generare decent returns. Both these criterias are met by debt funds.
Debt funds generate superior returns than bank FDs. Additionally, they do not have a lock-in period. Hence investors looking to create their contingency fund should invest in debt mutual funds.
Even retirees and senior citizens can invest in debt mutual funds as part of their retirement planning. Majority of retirees invest in traditional investment options like PPF, SCSS, POMIS etc but there is a major problem with these investments. They come with high lock-in periods. The only way to redeem before the lock-in period is by paying a high penalty.
To avoid this, debt mutual funds are the perfect investment option for retirees and senior citizens. Debt mutual funds are safe, generate high returns and do not have a lock-in period.
Now that we understand that every investor must have some allocation to debt funds, the question is, ‘which type of debt funds?’
Types of Debt Mutual Funds in India
Not all debt funds are suitable for all types of investors. Each type of debt fund carries its own risks and returns. Hence, Investors need to be very careful while investing in debt mutual funds.
Here is the detailed list of the different types of debt mutual funds in India.
The below grid explains which type of debt mutual fund you should invest in as per your investment horizons.
Things to Consider Before Investing in Debt Mutual Funds
Average Maturity: Average maturity is depicted in ‘years’. It tells you the average expiry date of the underlying bonds in your debt fund. Ideally you should match your investment horizon with the average maturity of the fund. Different types of debt funds have different average maturities.
For example: Aditya Birla Sun Life Liquid Fund has an average maturity of 0.08 years. But the average maturity of Aditya Birla Sun Life Corporate Bond Fund is 2.75 years.
Yield to Maturity (YTM): Yield to maturity tells you the average returns that the fund will generate by holding the underlying papers till maturity. YTM keeps on changing as the fund manager buys and sells underlying securities.
YTM helps you set your return expectation from the fund. For example: The YTM of Aditya Birla Sun Life Liquid Fund is 3.34%. Whereas the YTM of Aditya Birla Sun Life Corporate Bond Fund is 5.41%. So, before investing itself you know the average returns that you can expect.
Credit Ratings: Credit rating is very critical while investing in debt funds. Ideally you should invest in funds with a high credit rating. A high credit rating (AAA) means that the fund is highly stable.
Some debt funds like Corporate Bond Funds have a strict mandate to invest 80% of their corpus in AAA rated funds, so corporate bond funds are quite safe.
But Credit risk debt funds can invest in ‘A & Below’ papers which make them extremely risky. Hence investors should consider credit ratings of the underlying papers before investing.
Modified Duration: Modified duration shows you how sensitive your fund is to interest rate changes. Higher the modified duration, higher the sensitivity.
The modified duration of Aditya Birla Sun Life Liquid Fund is 0.08 years. But the modified duration of Aditya Birla Sun Life Corporate Bond Fund is 2.22 years.
This means that liquid funds are less sensitive to interest rate changes
Taxation: TDS is not applicable in debt mutual funds. Also debt mutual fund investors get the benefit of indexation. This helps investors reduce their tax liability. But if you fall in the highest tax bracket then it is recommended that you stay invested for 3 years to reduce your tax outgo.
How are Debt Funds Taxed? - Taxation of Debt Mutual Funds
The taxation period for debt mutual funds is 36 months.
you sell your debt fund before 36 months, you pay a Short Term Capital Gains Tax (STCG). The STCG will be added to your income and taxed as per the applicable tax slab. So, if you fall in the 10% tax slab, you pay 10% STCG tax.
If you sell your debt fund after 36 months, you pay a Long Term Capital Gains Tax (LTCG). The Long term capital gains tax on debt funds is 20% with indexation.
How To Invest in Debt Mutual Funds?
You can start investing in debt funds, absolutely FREE of cost by following the below steps:
- Open a FREE RankMF account.
- Access RankMF’s superior research methodology for FREE and select the best debt fund for investment.
- Start investing in the best debt mutual funds in India!
So, open a free mutual fund investment account with India’s best mutual fund research and investment platform - RankMF.