Debt Fund Investment Guide For Indians

Debt funds are a type of mutual fund that offers investors a low-risk investment option by investing in fixed-income securities such as bonds, treasury bills, and corporate bonds. They are ideal for investors seeking regular income with low volatility and are considered safer than equity funds. Debt funds are highly liquid and can be redeemed within a few days of placing a request. They are best suited for investors who are risk-averse, seeking short to medium-term investments, and looking for stable returns.

Understand the different types of debt funds

Debt funds are categorised based on the type of securities they invest in and the maturity of these securities. Debt funds can be classified as follows:

Overnight Funds

Overnight funds invest in securities that mature in one day, making them extremely safe as credit risk and interest rate risk are negligible. They are ideal for investors looking to park funds for a very short period.

Liquid Funds

Liquid funds invest in money market instruments that mature within 91 days. They are suitable for investors who want to park temporary cash surpluses for a few days, as they provide steady returns with minimum volatility.

Floating Rate Funds

Floating Rate Funds invest in floating-rate debt securities.

Ultra-Short Duration Funds

Ultra-short-duration funds invest in debt securities that mature in three to six months. They are suitable for investors with an investment horizon of at least three months. These funds are considered low-risk and may invest in lower-rated bonds to increase yields.

Low Duration Funds

Low duration funds invest in securities that mature within six to twelve months.

Money Market Funds

Money market funds invest in money market instruments with a maturity of up to one year. They are suitable for investors seeking low-risk debt securities for the short term.

Short Duration Funds

Short-duration funds invest in securities with a maturity of one to three years. They are recommended for investors with a horizon of one to three years. They usually earn higher returns than liquid and ultra-short-duration funds but show more volatility.

Medium Duration Funds

Medium-duration funds invest in debt securities with a maturity of three to four years.

Medium to Long Duration Funds

Medium-to-long-duration funds invest in debt securities with a maturity of four to seven years.

Long-Duration Funds

Long-duration funds invest in long maturity debt (over seven years).

Corporate Bond Funds

Corporate bond funds invest in corporate bonds. They are suitable for investors with a low-risk tolerance who want to invest in high-quality corporate bonds.

Banking and PSU Funds

Banking and PSU funds invest in the debts of banks, public sector undertakings, and public financial institutions. They are a moderate-risk product that seeks to balance yield, safety, and liquidity.

Gilt Funds

Gilt funds invest in government securities of varying maturities. They can be short or long-duration funds, depending on the maturity of their portfolio. Gilt funds have zero default risk as they invest in safe government securities.

Gilt Fund with 10-years Constant Duration

Gilt funds with 10-years constant duration invest in government securities with a maturity of 10 years.

Dynamic Funds

Dynamic funds invest in debt funds securities across maturities.

Credit Risk Funds

Credit risk funds invest in corporate bonds with ratings below the highest ratings.

Evaluate the risks associated with debt funds

Debt funds are considered to be low-risk investments, but they are not entirely risk-free. Here are the key risks associated with debt funds in India:

Interest Rate Risk

Interest rate risk is one of the primary risks in debt funds. This risk arises because bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This movement in bond prices impacts the net asset value (NAV) of the debt fund. Usually, funds with longer maturities experience greater price volatility due to interest rate changes. 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 that invest in securities with maturities of up to 91 days have negligible or very low interest rate risk.

Credit Risk

Credit risk, also known as default risk, is the risk that the issuer of a debt security may fail to make required payments or default on the debt. This risk is assessed using credit ratings assigned by agencies such as CRISIL, CARE, and ICRA. The riskiness of a debt fund can be understood by looking at its credit rating. In India, debt funds carry credit ratings from CRISIL, ICRA, and CARE, ranging from the lowest risk to the highest risk. Conservative investors should invest in debt funds with high credit ratings, such as those investing in AAA or A1-rated bonds, as these are considered safer and carry very little credit risk. On the other hand, debt funds investing in low credit-rated papers, such as B, C, or D-rated bonds, carry high credit risk and are only suitable for aggressive investors.

Liquidity Risk

Liquidity risk in debt funds arises when investors cannot easily sell their holdings. This risk is typically higher in close-ended debt funds, such as Fixed Maturity Plans (FMPs), which can only be redeemed on a fixed maturity date. These funds have low liquidity, making it challenging for investors to sell their holdings. To avoid liquidity risk, investors should consider open-ended debt funds, which can be redeemed at any time. There are 16 types of open-ended debt funds available in India.

Reinvestment Risk

Reinvestment risk occurs when the underlying debt papers in a debt fund mature, and the fund manager has to reinvest the proceeds in new debt instruments. This risk is higher when interest rates are falling, as the fund manager may have to reinvest in lower-interest-rate bonds, impacting the overall returns of the fund. To mitigate reinvestment risk, investors can consider long-term debt funds, which invest in long-term papers that do not mature frequently, thereby reducing the likelihood of reinvestment at lower interest rates.

Concentration Risk

Concentration risk arises when a debt fund manager fails to adequately diversify the portfolio. If a fund has a high concentration in a particular security and that security defaults, it can significantly impact the fund's NAV. Investors can avoid concentration risk by checking that the debt fund holds a diverse range of securities and that no single security makes up a large proportion of the portfolio.

Know the tax implications of investing in debt funds

Debt funds are taxed based on how long you hold them. If you hold debt funds for up to three years, they are considered short-term capital gains (STCG) and are taxed at the applicable income tax slab rate. If you hold them for more than three years, they are considered long-term capital gains (LTCG) and are taxed at 20% with indexation benefits.

Prior to April 1, 2023, the holding period rule determined the taxation of debt mutual funds. Short-term capital gains were taxed at slab rates, while long-term capital gains were taxed at 20% with an indexation benefit.

However, the Budget 2023 amendments mean that specified mutual funds will no longer receive indexation benefits when calculating LTCG. As a result, debt mutual funds will now be taxed at the applicable slab rates. This change brings the taxation of specified mutual funds in line with fixed deposits.

It's important to note that the tax on capital gains is levied only when the capital asset is transferred or sold. Additionally, investors can set off capital losses with debt-mutual fund gains and carry forward the capital losses to later years.

Dividends from debt funds are generally exempt from tax in the hands of investors. However, the mutual fund itself must pay a Dividend Distribution Tax, currently set at 28.325%.

Learn how to choose the right debt fund for your portfolio

When choosing a debt fund for your portfolio, there are several factors to consider, including your risk tolerance, investment horizon, and financial goals. Here are some guidelines to help you make an informed decision:

• Risk tolerance: Debt funds can vary in terms of risk, so it's important to select one that aligns with your risk tolerance. If you want a completely risk-free fund, gilt funds are a good option as they do not carry any credit risk. For investors who are more aggressive and willing to take on higher risks for higher returns, options like Monthly Income Plans (MIPs) and Credit Opportunity Funds are available.
• Investment horizon: Match your investment horizon with the average maturity of the debt fund. If you require funds within a year, avoid long-term debt funds, which typically have instruments with maturities of more than five years. Instead, opt for short-term debt funds or liquid/ultra-short-term funds.
• Interest rate outlook: Your view on the direction of interest rates is crucial in choosing a debt fund. If you anticipate declining interest rates, long-term debt funds or gilt funds are suitable. On the other hand, if you expect rising interest rates, stick to liquid funds or opt for floating-rate funds. Consult a financial advisor to fine-tune your interest rate outlook, as it is a complex subject.
• Fund evaluation: When evaluating debt funds, consider the average maturity of the fund's portfolio, modified duration, and Yield to Maturity (YTM). Compare the average maturity with your investment horizon to reduce liquidity risk. Modified duration indicates the sensitivity of bond prices to interest rate changes, with higher modified duration indicating greater sensitivity. YTM provides a measure of the expected returns from the fund.
• Fund characteristics: Consider the fund's credit profile, time horizon, and expected returns. Ensure that the fund's credit profile matches your risk tolerance. Assess whether the fund's time horizon aligns with your investment goals. Evaluate the potential returns offered by the fund and how they fit with your financial objectives.
• Diversification: Debt funds can provide diversification to your portfolio by investing in a range of secure instruments with fixed rates and maturities. This helps to stabilise your portfolio and reduce the impact of market fluctuations.
• Tax implications: Understand the tax implications of investing in debt funds. Short-term capital gains (holding period less than three years) are taxed according to your income tax slab, while long-term capital gains (holding period more than three years) are taxed at a rate of 20% with indexation benefits.
• Fund performance: Evaluate the track record of the debt fund by analysing its performance over different time horizons, such as three and five years. While past performance doesn't guarantee future results, it provides insight into the fund's management and consistency.
• Fund management: Consider the reputation and track record of the fund manager and the asset management company. Assess their experience and expertise in the investment domain.
• Expense ratio: The expense ratio represents the fees charged by the fund manager for managing the fund. Look for funds with a lower expense ratio, as this translates to higher returns for investors.
• Financial ratios: Utilise financial ratios such as standard deviation, Sharpe ratio, alpha, and beta to assess the risk and return characteristics of the debt fund. Higher standard deviation and beta indicate higher risk, while a higher Sharpe ratio suggests higher returns per unit of risk.

By carefully considering these factors, you can choose the right debt fund that aligns with your investment goals, risk tolerance, and expected returns. Remember to review your portfolio periodically and seek professional advice when needed to make informed investment decisions.

Compare debt funds with other investment options, such as equity funds or fixed deposits

Debt funds are a type of mutual fund that puts money in fixed-income instruments such as government and corporate bonds, treasury bills, commercial paper, certificates of deposit, and other money market instruments. They are considered to be less risky than equity investments but offer lower returns. Debt funds are ideal for investors seeking regular income with low risk.

Equity funds, on the other hand, invest primarily in shares of companies and related securities like derivatives (futures and options), which trade in the stock market. Equity funds carry a higher risk profile compared to debt funds, and investors need to have a moderately high to high-risk appetite and longer investment tenures. Equity funds are more volatile than debt funds but offer relatively higher returns over the long term.

Fixed deposits (FDs) have traditionally been a popular investment option in India, offering interest income while ensuring capital protection. However, debt mutual funds have gained popularity in recent years due to their potential to provide higher returns with liquidity. Debt funds are also tax-efficient compared to FDs, especially for investors in higher tax brackets.

When comparing debt funds with equity funds and fixed deposits, it is important to consider factors such as risk tolerance, investment horizon, return expectations, and tax implications. Debt funds are suitable for investors seeking regular income with low risk, while equity funds are for those with a higher risk appetite and longer investment tenures. Fixed deposits are a more conservative option, offering capital protection and fixed returns but may not keep up with inflation or provide the same level of tax efficiency as debt funds.

Frequently asked questions