Jun 14, 2017 4 min read

What are Debt Funds? Should You Invest in Them?

All you need to know about the debt mutual funds to start investing in them.
While equity investments in mutual fund provide capital growth in the long run, there is another category which offers regular income. If you have the desire to fetch recurrent profits with minimum risk, then you must take a glance at the features of debt funds as they are considered to be the best alternative for achieving such goals. By investing the money in fixed income securities like corporate bonds, government securities, treasury bills, money market instruments and so on, these funds tend to provide income generation on a regular basis. Let’s understand the concept of debt mutual funds and evaluate whether you should bet your money on them or not.

Understanding Debt Funds

When we buy the equity stock or share in a company, we hold the ownership rights and participate in its growth. But in the case of buying debt instruments like bonds or debentures, we give a loan to the issuing authority. The returns fetched on these investments are pre-decided along with the maturity of the instrument due to which they are termed as fixed income securities.

The debt mutual funds invest the pooled capital of investors in these instruments to fetch considerable returns for the investors. Due to this, the profits generated by this scheme as well as the risk appetite is measurable. These funds are not much affected by the market fluctuations, and thus the risk profile is quite low as compared to the equity mutual funds.

Different Types of Securities in Which Debt Funds Invest

In order to maintain a proper balance between risk and reward, and make a diversified portfolio to reduce the risk exposure, the debt funds invest in several instruments at the same time. Let’s have a look at them:

Dynamic Bond Funds - These instruments have a fluctuating average maturity period as they take interest rate calls and invest in both short and long-term securities.

Income Funds - These funds may take a call on interest rates and invest in debt securities with different maturities, but in most of the cases the income funds invest in the long-term maturity plans. Due to this, they become more stable and generate consistent profits.

Short-Term & Ultra Short-Term Debt Funds - This includes the debt funds which invest in the instruments having shorter maturity ranging from one to three years. They are best suited to the conservative investors as they are less prone to interest rate changes.

Liquid Funds - Here come the debt funds which invest in the instruments having maturity up to 91 days. These are the least risky funds and provide greater returns irrespective of the interest rate changes.

Gilt Funds - The Gilt funds invest specifically in the government securities. Such instruments are highly rated and don’t come with a credit risk as the government is not going to default on the loan it has taken from the public in the from of debt instruments. Accordingly, these funds are idle for the risk-averse investors having income generation as the primary goal.

Credit Opportunities Funds - Unlike other debt funds, they don’t invest as per the maturity of the debt instruments, rather try to earn higher returns by taking on call on credit risks. They hold low-rated bonds with higher interest rates and thus they are relatively riskier in comparison with other funds.

Fixed Maturity Plans - These are the close-ended debt schemes having a fixed maturity like government securities or corporate bonds. They have a set lock-in period which can be months or years before which one cannot redeem the funds. Investments can be made in these plans only during the initial offer period. Just like fixed deposits, the FMPs can offer extraordinary and tax-efficient returns. The difference is that they don’t guarantee returns.

How Interest Rates Affect Debt Funds?

The interest rates are the repo rate and reverse repo rate which is decided by the Reserve Bank of India. The repo rate is the rate at which RBI lends money to the commercial banks. There are various factors which result in the decrease or increase in the prevailing interest rates which further determine the rate at which institutions issue the bonds or debentures. The prices of fixed income instruments are inversely proportional to the interest rates, as, with a rise in rate, the income come down. Accordingly, when the interest rates fall or are intended to fall, these instruments earn higher profits.

Who Should Buy Debt Mutual Funds?

Among the various types of investors, the debt funds are best suited to those having a conservative risk appetite. They are a better alternatives to bank’s fixed deposits or savings account as they provide greater returns in their comparison and are more tax efficient. The interest income earned on these instruments is added to one’s total income and chargeable to tax as per the applicable slab rate. The long-term returns on the debt instruments are further beneficial for the investors as they are taxed at the rate of 10% or 20% after indexation, which comes down to around 6%. Hence, one can yield greater benefits by investing one’s capital in these funds and accomplish the short-term financial goals.

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