Debt Funds: Best Investment Options For You

Debt funds are a type of mutual fund that offers investors a low-risk option by investing in fixed-income securities such as bonds and treasury bills. They are ideal for those seeking a stable income stream and capital preservation while also diversifying their investment portfolios. Debt funds are considered less risky than equity funds as they invest in more secure instruments with fixed rates and maturity. When choosing a debt fund to invest in, it is important to consider factors such as investment objective, risk profile, past performance, and expense ratio.

Debt funds for risk-averse investors

Debt funds are a type of mutual fund that provides investors with a low-risk investment option. They predominantly invest in fixed-income instruments such as treasury bills, corporate bonds, government securities, and other debt and money market instruments.

Debt funds are ideal for risk-averse investors who are looking for a stable income stream and capital preservation. Here are some of the best debt funds for risk-averse investors:

• Liquid Funds: Liquid funds are highly liquid and have a very short maturity period, usually up to 91 days. They are suitable for investors who want to park their surplus funds in a safe and flexible investment option. Examples include Tata Liquid Fund, Quantum Liquid Fund, and ICICI Prudential Liquid Fund.
• Money Market Funds: These funds invest in debt instruments with maturities of up to one year. They aim to generate returns from interest income while offering some scope for capital gains. An example is the Tata Money Market Fund.
• Overnight Funds: Overnight funds invest in securities with a maturity of one day, typically in money market instruments. They prioritize liquidity and convenience over high returns. An example is the Nippon India Ultra Short Duration Fund.
• Ultra-Short Duration Funds: These funds are suitable for investors with an investment horizon of at least three months. They offer slightly higher returns than liquid funds while still being considered low-risk. Examples include Nippon India Ultra Short Duration Fund and HDFC Overnight Fund.
• Short-Term Funds: Short-term funds invest in a combination of short and long-term debt, typically with maturities between one and three years. They offer higher returns than liquid and ultra-short-duration funds but also come with more volatility. An example is the ICICI Prudential Corporate Bond Fund.
• Corporate Bond Funds: These funds invest primarily in high-quality corporate bonds, with at least 80% of their portfolio in AA+ or higher-rated bonds. They are suitable for risk-averse investors seeking regular income and capital preservation. An example is the Nippon India Corporate Bond Fund.
• Banking and PSU Funds: These funds invest in debt securities of banks and public sector companies, with at least 80% of their portfolio in these sectors. They are considered relatively safe due to the nature of the underlying securities. An example is the ICICI Prudential Banking & PSU Debt Fund.

It is important to note that while debt funds are considered low-risk, they are not entirely risk-free. Investors should carefully consider factors such as credit risk, interest rate risk, liquidity risk, and the expense ratio before investing in any debt fund.

Debt funds vs fixed deposits

Debt funds and fixed deposits are both investment options for those looking to grow their savings. However, there are several differences between the two that investors should be aware of before deciding which option is best for them.

Risk

Fixed deposits (FDs) are considered low-risk investments as they offer a guaranteed return on savings. The bank provides assurance of capital safety, and FDs are generally thought to be risk-free. Debt funds, on the other hand, are subject to market risks and there is no assurance of capital safety. There are two types of risk associated with debt funds: interest rate risk and credit risk. Interest rate risk depends on the duration of the fund, with funds that invest primarily in money market instruments having lower interest rate risk than those with longer maturities. Credit risk depends on the credit ratings of the underlying securities.

Returns

FDs pay back the principal amount along with accrued interest at a fixed rate on maturity. Debt funds do not give assured returns, and their returns are market-linked. Historical data suggests that debt funds have usually outperformed FDs of similar tenures.

Liquidity

Both FDs and debt funds are highly liquid, with no lock-in period for either option. However, some banks may charge penalties for premature FD withdrawals, and debt fund redemptions within the exit load period will attract an exit load fee.

Taxation

Interest on FDs is taxed during the tenure of the investment and on maturity, according to the investor's income tax rate. Debt funds, on the other hand, enjoy a tax advantage, especially for investors in higher tax brackets. Short-term capital gains in debt funds (investments held for less than 3 years) are taxed at the same rate as FDs, while long-term capital gains (investments held for more than 3 years) are taxed at 20% with indexation benefits.

Transparency

FDs are considered very safe instruments, but bank defaults are possible. Debt funds, on the other hand, are very transparent as the scheme portfolio is disclosed monthly by asset management companies, providing complete information on instrument names, credit ratings, and exposure.

Investment Horizon

Debt funds can be considered for an investment horizon of 1 day to up to 3 years, while FDs typically have a fixed maturity date.

In summary, if capital safety and assured returns are paramount, then FDs may be the best option. However, debt funds can provide potentially superior risk-adjusted returns and taxation benefits, making them a good choice for those looking to invest a portion of their fixed income assets.

Short-term vs long-term debt funds

Debt funds are a type of mutual fund that generates returns by lending money to governments and companies. The lending duration and the type of borrower determine the risk level of a debt fund.

Short-term debt funds typically have a maturity period of up to 3 years and are considered a low-risk investment option. They are ideal for investors who are risk-averse and seeking stable returns. Short-term debt funds are also suitable for those who are investing for a short period, such as a few weeks to a year. Some examples of short-term debt funds include liquid funds and ultra-short-term debt funds, which offer returns that are significantly higher than savings accounts.

Long-term debt funds, on the other hand, have a maturity period of more than 3 years and can provide higher returns compared to short-term debt funds. However, they are also more vulnerable to changes in interest rates, which can impact their returns. Long-term debt funds are suitable for investors who are comfortable with a higher risk and are investing for the long term, such as for retirement planning. Examples of long-term debt funds include medium-to-long-duration funds and long-duration funds.

When choosing between short-term and long-term debt funds, it is important to consider your investment goals, time horizon, and risk tolerance. Short-term debt funds offer more stability and liquidity, while long-term debt funds have the potential for higher returns over time.

Additionally, it is worth noting that debt funds are generally considered to be one of the least risky types of mutual funds and can provide a steady income stream. They are a good option for investors who are seeking regular income and capital preservation while also diversifying their investment portfolios.

Debt fund taxation

In India, the taxation of debt funds changed in the 2023 Union Budget. For investments made before April 1, 2023, debt fund taxation was as follows:

• Short-term capital gains (STCG): If debt fund units were sold within three years of purchase, gains were taxed as short-term capital gains at the investor's income tax slab rate.
• Long-term capital gains (LTCG): If debt fund units were sold after three years of purchase, gains were taxed as long-term capital gains at a rate of 20% after indexation. Indexation adjusts the purchase price of the debt fund units for inflation, reducing the amount of gain subject to tax.

However, for investments made after April 1, 2023, the benefit of indexation for long-term capital gains is no longer available for debt mutual funds. Instead, capital gains from debt funds, regardless of the holding period, are now added to the investor's taxable income and taxed at their applicable income tax slab rate.

Dividends from debt funds are also taxed. Since 2020, dividends have been taxed classically, meaning they are added to the investor's total income and taxed at their income tax slab rate.

In the United States, debt funds are typically taxed as regular income, regardless of how long you hold them. When you receive a distribution from a debt fund or sell your shares, the portion of the distribution or sale price that represents accrued interest is generally taxed as ordinary income. If you sell your shares for more than your initial investment, you may also have a capital gain, which is generally taxed at the lower capital gains tax rate if you held the shares for more than one year.

Types of debt funds

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 government securities. They are ideal for those seeking a safe investment instrument with steady returns. Here are some of the most common types of debt funds:

• Money Market Funds: These funds invest in debt instruments with maturities of up to one year. They aim to generate returns from interest income and typically have a slightly longer duration, offering some scope for capital gains.
• Overnight Funds: Overnight funds invest in securities that mature in one day, usually in money market instruments. These funds focus on providing liquidity and convenience rather than high returns. They are suitable for investors looking to park funds for a very short period, and their risk is low due to the short maturity period.
• Ultra-Short Duration Funds: These funds are suitable for investors with an investment horizon of at least three months. They offer slightly higher yields than liquid funds and are considered a low-risk investment option. The maturity period for ultra-short duration funds typically ranges from three to six months.
• Short-Term Funds: Short-term funds have a maturity period of 6 to 12 months and invest in debt securities. They are a good choice for investors who want to invest for less than a year and offer moderate risk with better returns than liquid and ultra-short duration funds.
• Medium-Term, Medium to Long-Duration, and Long-Duration Funds: This category of debt funds invests in debt instruments with maturity periods ranging from 3-4 years, 4-7 years, and more than 7 years, respectively. These funds offer comparatively higher returns but carry the risk of varying interest rates.
• Corporate Bond Funds: Corporate bond funds must invest at least 80% of their portfolio in AA+ or higher-rated corporate bonds. They are suitable for risk-averse investors seeking regular income and safety of principal.
• Dynamic Funds: Dynamic funds invest in different types of debt instruments, and the fund manager decides on the investment strategy based on market behaviour. These funds have a moderate risk as their timeframe is typically between three and five years.
• Banking and PSU Funds: This type of debt fund invests primarily in banking and public sector companies. The fund manager allocates 80% of the total investment to debt securities offered by banks and PSU companies. These bonds are considered relatively safe.
• Credit Risk Funds: Credit risk funds invest a minimum of 65% of their total assets in corporate bonds rated AA or below. Consequently, they usually generate higher yields than more conservative corporate bond funds. Investors willing to take on higher default risk may consider this option.
• Gilt Debt Funds: Gilt debt funds solely invest in securities issued by central and state governments, with maturity periods ranging from medium to long-term. Since these funds are government-issued, there is no credit risk, and capital remains safe. However, government securities are susceptible to changes in interest rates. Gilt funds are suitable for those willing to invest long-term and prefer government-backed options.
• Floating Rate Funds: Floating-rate funds primarily invest in instruments offering a floating interest rate, which is periodically reset based on interest rate movements. The primary objective is to minimise the volatility of investment returns.
• Fixed Maturity Plans (FMPs): FMPs have a fixed lock-in period ranging from months to years. Due to this lock-in period, they are unaffected by changing interest rates, resulting in a stable Net Asset Value (NAV). These funds are considered tax-efficient and are regarded as one of the best alternatives to fixed deposits.
• Credit Opportunities Funds: Credit opportunities funds are relatively new and unique compared to other debt funds. They do not invest based on the maturities of debt instruments but instead focus on earning higher returns by taking on credit risks or investing in lower-rated bonds with higher interest rates. These funds are considered relatively riskier.

Frequently asked questions