What is Debt Funds?
If you believe that mutual funds are solely for long term investments, you may not be familiar with debt funds. A debt fund is a mutual fund category that invests capital in fixed income instruments like corporate and government bonds or corporate debt securities and money market instruments. They are known for their low-risk profile and relatively stable investment options that help investors preserve capital or achieve low-risk income distributions. And that’s why they make a good investment option for the short term. However, because the risk is relatively low, the returns are also lower than equity mutual funds.
Below, we’ll go into detail about debt funds and talk about how they work, types of debt funds, what their benefits are, and whether you should invest in them.
What are Debt Funds?
Like the name suggests, debt is a loan, and a mutual fund that gives away loans to the government, companies or financial entities hoping to raise funds is known as debt funds. They invest in fixed income securities like treasury bills, commercial paper, etc.
The rate of interest and the maturity period are predetermined by the entities issuing the debt instrument. The key objective of investing here is capital appreciation with limited risk exposure.
How Debt Funds Work
Every mutual fund has a rating that indicates whether or not it’s a high-quality investment. The same goes for debt funds. Their credit rating helps investors understand whether the debt issuer might default on the payment. It’s a professional debt fund manager’s responsibility to separate the high-quality funds from the low-quality ones so that the investor can enjoy stable returns. The higher the credit rating, the more likely they are to honour their pay interest regularly.
Types of Debt Funds
Debt funds are diversified as they invest in various classes of securities to reduce risk exposure and increase the chances of earning stable returns. While these returns may not be guaranteed, they tend to fall within specific ranges, making them a safer investment alternative for risk-averse investors. Debt funds are also categorized based on the tenure of investment. The different types of debt funds are:
Short/Medium/Long-Term Funds
The maturity period for short-term debt funds lies between 1 to 3 years. If you would like to park your money in a safe place that might earn higher interest than a bank savings account, this would be the ideal option for you. On the other hand, medium-term funds mature in 3 to 5 years, while a long-term debt fund comes with a maturity that exceeds 5 years. Since the latter have long tenures during which interest rates can fluctuate, they are viewed as relatively high-risk.
Liquid Debt Funds
These funds are highly liquid as they invest in instruments with a maturity period of fewer than 91 days and may be considered the least risky mutual fund investment. Most companies allow the investor to withdraw up to Rs. 50,000 under their instant redemption facility, which is why these funds are so popular among short-term investors. An exit load may be applicable if you withdraw within seven days after you’ve invested. Otherwise, you can withdraw your money without any penalty.
Gilt Funds
These are debt funds that invest only in government securities, which are high-rated and carry the lowest default risk. If you’re a risk-averse investor looking to invest in fixed-income funds safely, this might be an ideal option for you.
Fixed Maturity Plans
Also known as FMPs, these are securities that come with a lock-in period based on the plan you’ll be investing in. There is an initial offer period during which you have to invest. Their features are similar to that of a Fixed Deposit, except FMPs are more tax-efficient and can potentially deliver higher returns.
Benefits of Debt Funds
There are multiple benefits of investing in debt mutual funds:
Stable Returns
Like other mutual funds, debt funds also aim to help you with capital appreciation. However, they boast a lower risk profile than equity funds because they invest in fixed-interest instruments. Keep in mind that even with debt funds, the returns are not guaranteed. Overall, they are much less volatile as compared to other types of mutual funds.
Liquidity
Most debt mutual funds come without a lock-in period, making them easy to redeem at any time. However, some funds may charge an exit load for early withdrawal, while others may not.
Tax Saving
One of the highlights that make debt funds so attractive is their tax efficiency. You’re not required to pay taxes until you decide to redeem your investments, and even then, you only have to pay for the proceeds. Your returns may fall under Short-Term Capital Gains or Long-Term Capital Gains. For the latter, you can also take advantage of indexation and increase your post-tax returns.
Should You Invest in Debt Funds?
The answer will depend on your financial goals and your general approach to investing. Debt funds help diversify your portfolio and distribute your risk exposure as they are moderately stable. Whether you’re a short-term investor looking for low-risk, high-reward avenues or a medium-term investor hoping to save up for necessary expenses down the line, investing in debt funds can be suitable for those who don’t want to take too big a risk.
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