Debt Fund Investment: Strategies For Success

Debt funds are a type of mutual fund or exchange-traded fund (ETF) that primarily invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. They are considered low-risk investment options, providing stable and regular returns with high liquidity and reasonable safety. Debt funds are ideal for investors seeking regular income with low volatility and are a good alternative for those saving in traditional fixed-income products like bank deposits. When considering investing in debt funds, it is important to evaluate the associated risks, such as interest rate risk and credit risk, and to understand the return calculations, which include income payouts and capital gains.

Debt funds vs. fixed-income investments

Debt funds and fixed-income investments are very similar. Debt funds are a type of mutual fund scheme that invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. Fixed-income investments are those that pay investors a fixed interest or dividend payment until they mature.

Advantages of Debt Funds

Debt funds are ideal for investors who want a regular income but are risk-averse. They are less volatile and therefore less risky than equity funds. They also have a low-cost structure, stable returns, high liquidity, and reasonable safety.

Advantages of Fixed-Income Investments

Fixed-income investments provide a steady stream of income over the life of the bond or debt instrument. They are also good for investors who want a diversified portfolio. They are considered to have lower returns and lower risk than stocks. Fixed-income securities are also debt instruments that pay a fixed rate of interest.

Disadvantages of Debt Funds

There are four major risks associated with debt funds: interest rate risk, inflation risk, credit risk, and liquidity risk.

Disadvantages of Fixed-Income Investments

Fixed-income investments have lower returns than other investments and are susceptible to interest rate risk, inflation risk, and credit and default risk.

The benefits of investing in debt funds

Debt funds are a type of mutual fund scheme that invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. They are often referred to as bond funds or fixed-income funds.

Diversification and Reduced Risk

Debt funds offer diversification from stock market risk. They are generally considered to carry lower risk than stocks as they are less sensitive to macro risks like economic downturns, sectoral downturns, and geopolitical events. This makes them ideal for investors who are risk-averse but still want regular income.

Capital Preservation

Debt funds are well-suited for capital preservation, which means protecting the absolute value of your investment. Since fixed-income assets typically carry less risk, they are a good choice for investors who may not have a long time horizon to recoup losses.

Regular Income Generation

Debt funds provide a steady source of income in the form of regular dividends on the bond funds. This makes them attractive to investors seeking regular income with low volatility.

Higher Returns with Increased Risk

While debt funds generally offer lower returns than equity funds, investors can seek higher returns by assuming more credit risk or interest rate risk. This strategy is commonly employed in debt funds to boost total returns.

High Liquidity

Debt funds are easy to liquidate, as they can be redeemed at any time without the lock-in periods and premature withdrawal penalties often associated with other fixed-income investments, such as bank deposits.

Tax Advantages

Debt funds offer more tax advantages than bank deposits. While money in a fixed deposit earns lower interest and is taxed annually, debt funds offer higher returns and are only taxed upon redemption of the units.

Suitable for New Investors

Due to their low-risk nature, debt funds are a good starting point for new investors before they move on to market-linked equity funds. They can provide a steady return without the fear of losing money due to a market crash.

Risks associated with debt funds

Debt funds are considered less risky than equity funds, but there are still risks associated with them. Here are some of the key risks to be aware of before investing in debt funds:

Interest Rate Risk

Interest rate risk is one of the primary risks in debt funds. Bond prices and interest rates have an inverse relationship, meaning that when interest rates rise, bond prices fall, and vice versa. This movement in interest rates can cause price volatility in bond markets, and longer maturity bonds tend to be more volatile. While interest rate risk is present in all debt funds, its degree can vary. For example, gilt funds with longer maturities carry higher interest rate risk, while liquid funds with shorter maturities have negligible or very low risk.

Credit Risk

Credit risk is the risk of default by the issuer of the debt. In other words, it is the failure of the issuer to pay interest or the principal amount. Credit risk is also known as business or financial risk, and it is higher for smaller companies. If an issuer defaults, the investor may not receive the full value of their investment. Credit rating agencies assess the credit risk of fixed-income instruments and assign ratings based on the issuer's financial strength. A downgrade in credit rating can lead to a fall in the price of the instrument.

Inflation Risk

Inflation risk is another concern for debt fund investors. Inflation can cause the rupee to lose value over time due to rising prices. While bonds provide fixed returns at regular intervals, if the inflation rate grows faster than the fixed income, the investor's purchasing power decreases. This loss of purchasing power is what is referred to as a negative "real return".

Liquidity Risk

Liquidity risk refers to the possibility that an investor may want to sell a fixed-income asset but cannot find a buyer. It can also apply to the fund itself if it invests in unlisted or illiquid instruments.

Concentration Risk

Concentration risk refers to the proportion of holdings in a single security or bond. A higher concentration in one security means a greater risk. For example, if a 10% exposure in a single security defaults, the net asset value (NAV) of the fund will be impacted to that extent.

How to choose a suitable debt fund

When choosing a debt fund, investors should consider their risk appetite, investment horizon, and financial goals. There are more than 15 categories of debt funds, each serving a different purpose and catering to different investor needs. Here are some key factors to consider when selecting a suitable debt fund:

Investment Tenure and Risk Appetite

Match your investment tenure and risk appetite to the fund's duration and credit risk. Longer-duration funds are typically more volatile than shorter-duration funds concerning interest rate risk. If you have a long investment tenure, consider longer-duration funds, and if you have a short investment tenure, opt for shorter-duration funds. Examples of short-duration funds include overnight, liquid, and ultra-short-duration funds. For medium-term investments (1 to 3 years), consider low, money market, or short-duration funds. If you're investing for the long term (more than 3 years), long-duration, dynamic bond, or gilt funds may be suitable.

Credit Risk

Credit risk is the risk of the issuer defaulting on interest or principal payments. Lower-rated debt instruments offer higher yields but carry a higher risk of default. Some fund managers may invest in lower-rated instruments to capture these higher yields. Assess your comfort level with credit risk, and if you want to minimise this risk, consider investing in high-credit-quality schemes such as corporate bond funds, banking and PSU funds, or gilt funds.

Interest Rate Risk

Interest rate risk refers to the impact of changing interest rates on the value of debt securities. When interest rates rise, prices of existing debt securities tend to fall, leading to a potential decline in the net asset value (NAV) of the debt fund. Conversely, when interest rates fall, prices of existing debt securities tend to rise, resulting in an increase in the NAV. Longer-duration funds are generally more sensitive to interest rate risk than shorter-duration funds. To mitigate this risk, consider investing in debt funds with shorter durations or those that focus on high-quality debt securities.

Liquidity Risk

Liquidity risk is the possibility of not being able to sell the fund's underlying debt securities quickly enough to meet redemption requests from investors. This risk is higher for funds that invest in less liquid securities, such as lower-rated corporate bonds or those with longer maturities. To address liquidity risk, debt fund managers typically maintain a certain level of cash or liquid investments to meet sudden redemption requests. Investors should also consider the liquidity profile of the fund and understand the credit quality and maturity of the underlying securities.

Yield-to-Maturity (YTM)

Instead of focusing solely on past returns, consider the Yield to Maturity (YTM) of a debt fund. YTM, along with the expense ratio, can provide an estimate of the fund's future returns. An investor can expect returns equal to YTM minus the expense ratio.

Fund Manager's Capability

Consider the fund manager's capability to manage the underlying securities effectively. Assess their ability to maintain an appropriate mix of short-term and long-term securities, depending on market conditions. Also, evaluate their track record in credit risk management and ensuring diversification across different sectors, maturities, and credit ratings.

Taxation of debt funds

Debt funds are taxed based on the holding period and the type of fund. The holding period refers to the time between the purchase and sale of the mutual fund units. The longer you hold onto your mutual fund units, the more tax-efficient they become.

Debt funds are taxed at different rates for short-term and long-term capital gains. If the debt mutual fund unit is sold within 36 months (three years) of purchase, the gains are considered short-term capital gains (STCG) and are taxed at slab rates. If they are sold after 36 months, the gains are considered long-term capital gains (LTCG).

Prior to April 1, 2023, LTCG from debt funds were taxed at 20% with an indexation benefit, which adjusted the gains made by investors for inflation. However, the Budget 2023 brought changes to the taxation of debt funds. Now, debt funds will no longer receive the indexation benefit and will be taxed at the applicable slab rates. This change brings the taxation of specified mutual funds in line with fixed deposits and may impact the attractiveness of debt funds as an investment option, as the tax burden on profits may increase.

It is important to note that debt funds are only subject to taxation when the investments are sold, providing the advantage of deferring taxes. Additionally, debt funds do not have exit loads after a certain period, providing greater liquidity and cost-effectiveness compared to fixed deposits.

Frequently asked questions