(A) About Debt Mutual Funds
A debt fund is a Mutual Fund scheme that invests in fixed-income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also refer to as Fixed Income Funds or Bond Funds.
(B) How does it Works
Based on the credit ratings of the securities, debt funds invest in a range of securities. The danger 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 management makes sure 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 securities, 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 rising interest rate environment makes him more inclined to invest in short-term securities.
(C) Types of Debt funds
There are different types of debt mutual funds available for investors to choose from based on the maturity period, risk profile and investment objective of the investor.
(i) Overnight Fund
This fund invests in securities which have a maturity period of 1 day. Overnight Funds carry minimal credit risk and interest rate risk owing to such a short maturity period and are hence are considers to be relatively stable.
(ii) Liquid Funds
Liquid funds invest in debt instruments with a maturity of not more than 91 days. This makes them almost risk-free. Liquid funds have rarely seen negative returns. These funds are better alternatives to savings bank accounts as they provide similar liquidity with higher yields. Many mutual fund companies offer instant redemption on liquid fund investments through unique debit cards.
(iii) Dynamic Bond Funds
As the name suggests, these are ‘dynamic’ funds. Meaning, the fund manager keeps changing portfolio composition as per the fluctuating interest rate regime. Dynamic bond funds have different average maturity periods as these funds take interest rate calls and invest in instruments of longer and as well as shorter maturities.
(iv) Income Funds
Income Funds take a call on the interest rates and invest predominantly in debt securities with extended maturities. This makes them more stable than dynamic bond funds. The average maturity of income funds is around five to six years.
(v) Ultra-Short Duration Fund
Ultra-Short Duration Fund invests in debt securities and money market instruments such that the Macaulay Duration of the portfolio is between 3-6 months.
(vi) Short Duration Fund
Short Duration Fund invests in debt securities and money market instruments such that the Macaulay Duration of the portfolio is between 1-3 years.
(vii) Gilt Fund
Gilt Funds invest in only high–rated government securities with shallow credit risk. Since the government seldom defaults on the loan it takes in the form of debt instruments; gilt funds are an ideal choice for risk-averse fixed-income investors.
(viii) Credit Opportunities Funds
These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds do not invest as per the maturities of debt instruments. These funds try to earn higher returns by taking a call on credit risks or by holding lower-rated bonds that come with higher interest rates. Credit opportunities funds are relatively riskier debt funds.
(ix) Medium Duration Fund
Medium Duration Fund invests in debt securities and money market instruments such that the Macaulay Duration of the portfolio is between 3-4 years.
(x) Corporate Bond Fund
Corporate Bond Fund predominantly invests in corporate bonds rated AA+ and above. It is a good option for investors having a moderate risk appetite who want to invest in papers having relatively lower credit risk.
(xi) Banking & PSU Fund
Banking & PSU Fund invests at least 80% of its assets in debt and money market securities of Banks, PSU (Public Sector Undertakings), Public Financial Institutions and Municipal Bodies.
(xii) Money Market Fund
Money Market Fund invests in money market securities with a maximum maturity of 1 year. This fund is a good alternative to park surplus money for the short term. It can also be used as an emergency fund as it is relatively highly liquid and has the potential to generate better returns than traditional avenues.
(xiii) Floater Fund
These are the funds which invest a minimum of 65% of their investible corpus in floating-rate instruments. These funds carry a low interest-rate risk.
(xiv) Medium to Long Duration Fund
They invest in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between 4-7 years.
(xv) Low Duration
These are funds which invest in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between 6-12 months.
(xvi) Fixed Maturity Plans
Fixed maturity plans (FMP) are closed-ended debt funds. These funds also invest in fixed-income securities such as corporate bonds and government securities. They have a fixed locked-in period. This horizon can be in months or years. However, you can invest only during the initial offer period. It is like a fixed deposit that can deliver superior, tax-efficient returns but does not guarantee high returns.
(xvii) Guilt Fund (with 10 years duration)
Gilt funds with a 10-year constant duration are debt funds that invest in government securities, having a constant maturity of ten years. It puts money in central and state government securities with a Macaulay duration of 10 years. It could offer a higher return as compared to medium-duration funds.
(D) Benefits of debt funds
Unlike traditional avenues, debt funds don’t have a lock-in period and can be redeem at any time subject to applicable exit loads. Debt funds are consider liquid as they can withdraw on any business day. Few Liquid funds also offer instant redemption facilities which allow investors to redeem up to ₹50,000 instantly per day per scheme per investor.
(ii) Tax Efficient
Debt funds can be more tax efficient than traditional investment avenues. Debt funds are taxed only when they are redeemed and the tax is only paid on the redemption proceeds unlike some of the traditional avenues which deduct TDS on the interest earned every year. The dividend received from debt funds is taxable in the hands of the investor according to the investor’s tax slab. Debt funds can be more tax efficient with LTCG (Long Term Capital Gain) of 20% along with the benefit of indexation when the investments are held for more than 3 years which can help provide better post-tax returns.
Debt funds are relatively less volatile than equity funds and can provide stability to an investor’s portfolio. This can help diversify an investor’s portfolio and bring down the overall risk. They are also consider to be a good source of relatively stable income over a period of time.
(iv) Potential for better returns than traditional investment avenues
Investments in debt funds have the potential to generate better returns than traditional investment avenues. An investor can also take advantage of changing interest rates and could generate income by choosing the right fund matching his risk appetite and investment horizon.
(E) Taxability of Debt Funds
If the units of the scheme are held for less than 3 years, then any gains are calculated as STCG(Short Term Capital Gain) and are taxed as per an individual’s tax slab whereas if they are held for more than 3 years then the gains will be calculated as LTCG(Long Term Capital Gain) and will be taxed at 20% with the benefit of indexation.
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