Debt Funds Explained

This article on #debt funds also known as #bond funds deals with all of its technology as well as financial aspects of it. After going through this article you would understand the meaning of debt fund; various types of debt funds; #interest rate offered on debt funds; what #returns do debt funds give; taxation on debt funds; also a comparison of debt funds with a fixed deposit (#FD) and #equity fund.

Debt Fund Meaning

A debt fund or bond fund is a mutual fund investment option that invests your money into fixed-income securities like #corporate bonds, #government securities, #debentures, and other financial instruments. Debt fund investment could be short-term, medium-term, and long-term, depending on the bonds.

Debt fund works by buying the bonds and earn interest over the money invested. It is very similar to bank #Fixed Deposits (FD) wherein you lend your money to the bank in exchange for fixed interest. Debt fund investment is suitable for investors with a low-risk appetite. As the risk is decreased so the return rates are also lower than equities.

Point to be noted that all debt funds have a pre-decided maturity date and interest rate, this is the reason why they are called fixed-income securities.

Debt Fund Types

There are different types of debt funds available in the market, each suitable for different types of investors. The main differentiating factor between each type of debt mutual fund is the maturity date and interest rate. The following are different types of debt funds.

1) Liquid Funds

The Liquid Funds invest in debt instruments with a maturity period of not exceeding 91 days. It is the best alternative against savings accounts and offers better returns. No liquid debt fund has been recorded to date for giving negative returns. These funds offer the best short term investment alternative for risk-free investments.

2) Money Market Fund

As the name suggests, these funds invest in the money market instruments and have a maturity period of one year at the maximum. These types of funds are suits the narrative of an investor looking for short term low risk investment.

3) Dynamic Bond Fund

These funds invest in debt instruments with varying maturity ranging from three years to five years; however, they also do have a certain amount of risk factor. These funds are suitable for investors ready to take a moderate risk and wait for a period of 3-5 years.

4) Corporate Bond Fund

These types of funds invest in high-quality corporate bonds with good ratings. These funds lend at least 80% of their money into high rating corporate; best suitable for investors with low-risk appetite.

5) Banking and PSU Funds

These funds invest 80% of their money in the banking sector and PSUs (Public Sector Undertakings).

6) Gilt Fund

These are the debt funds that only invest in bonds and fixed interest securities issued by the state and central governments. The maturity period varies as per the bond and they carry minimal risk.

7) Credit Risk Fund

These funds are second in line to corporate bond funds, that is, they invest 65% of their money in buying the corporate bond of companies just below the high ranking ones. Therefore, they carry moderate risk but high returns.

8) Floater Fund

These funds invest 65% of their money in floating rate instruments and therefore carry low interest and risk.

9) Overnight Funds

As the name suggests these funds invest in debt securities with a maturity period of just one day. They are considered a safe investment with no risk involved.

10) Ultra – Short Duration Fund

These funds invest in debt securities and money market instruments with a maturity period ranging between three to six months.

11) Low Duration Funds

These funds invest in debt securities and money market instruments with a maturity period ranging between six to twelve months.

12) Short Duration Funds

These funds invest in debt securities and money market instruments with a maturity period ranging from one to three years.

13) Medium Duration Funds

These funds invest in debt securities and money market instruments with a maturity period ranging between three to four years.

14) Medium to Long Duration Funds

These funds invest in debt securities and money market instruments with a maturity period ranging between four to seven years.

15) Long Duration Funds

These funds invest in debt securities and money market instruments with a maturity period of more than seven years.

Debt Fund Returns

The returns of various types of debt funds may vary from 8.5% to 11% or even more, depending on the instrument in which the money is invested the maturity period, and the risk factor. In 2008, long-term debt funds gave a return of around 25.33%, but in 2009 a rise in interest rates caused bond prices to dip.

No debt funds are believed to never give negative returns but under some circumstances, they can. Though debt funds are not volatile as equities and don’t carry the risk either, there are some exceptions to it.

When interest rates are rising, long-term debt funds can give negative returns; this is because the value of low-interest rate bonds goes down in the secondary bond market, with the hike in interest.

For the period Dec’18 to Dec’19, long term gilt fund had given an interest of -4.2%, even some of the worst-performing funds lost over 11%.

Debt Mutual Fund Taxation

The capital gains earned on a debt mutual fund up to a period of three years is called ‘Short Term Capital Gain (STCG)’. Whatever your taxable income may be, this STCG is added to it and the tax is applied as per the normal income tax slab applicable.

If the scheme units are held for a period of more than three years then the capital gain earned will fall in the category of ‘Long Term Capital Gain (LTCG)’ and is taxable at the rate of 20% with indexation benefits.

Should You Invest in Debt Fund?

A debt fund is suitable for an investor with low-risk capability. Returns are expected and suit the narrative of low risk, moderate gain investor.

Which Debt Fund Should You Go For?

An important point to consider before investing in debt fund is that the long term funds are more susceptible to interest rate changes; like we have seen in the above example of FY 2008 and 2009.

Both long (10-15 years) and medium (3-4 years) term debt funds are susceptible to interest rate changes and carry a certain risk factor; on the other hand, short-duration funds (=<1 year) stay largely immune to the changes.

Floating Term Debt Funds could be a better alternative as they offer a benchmark interest rate and are therefore immune to the changes in the interest rates.

Choosing the best debt fund could be tricky as there are several options available. However, the points given below will help you in narrowing down on the fund type that suits your requirements and condition.

• Be crystal clear about your investment objective i.e. you are making the investment for future emergencies or something else.
• Fix your time horizon for the investment – low term, medium-term, or long term.
• Recommended to keenly check the history of the debt fund you are intending to invest.
• If you are investing through a fund manager, then do check his/her past performances.

Conclusion

Though debt funds are considered a safe haven for investors looking for low-risk opportunities, it is highly recommended that one get the priorities lined up before choosing a plan. Also, a peek into the past performance of the fund will help one make a calculative and near-exact assessment of the returns.