Debt Mutual Fund Investment: What You Need To Know

Debt mutual funds are a type of investment vehicle that pools money from multiple investors to purchase a diversified portfolio of fixed-income securities, such as corporate and government bonds, treasury bills, commercial papers, and other money market instruments. These funds offer stable and steady investment options for those seeking regular income with lower risk compared to equity investments. The main advantages of investing in debt mutual funds include a low-cost structure, stable returns, high liquidity, and reasonable safety. They are ideal for investors who want to achieve their financial goals in a tax-efficient manner while maintaining a low-volatile investment portfolio.

Characteristics of Debt Mutual Fund Investments

Debt Mutual Fund Types

Debt Mutual Funds are categorised based on the types of securities they invest in and the maturity (time horizon) of these securities. Debt securities include bonds issued by corporates, banks and governments, debentures issued by corporates, and money market instruments like commercial papers and certificates of deposit (CDs) issued by banks.

Overnight Funds

These invest in 1-day maturity papers (securities). They are considered extremely safe since both credit risk and interest rate risk are negligible.

Liquid Funds

Liquid funds invest in money market instruments like commercial papers, certificates of deposits, and treasury bills that mature within 91 days. They have very low interest rate risk but may have exposure to credit risk depending on the credit quality of the underlying instruments.

Money Market Funds

Money market funds invest in money market instruments like commercial papers, certificates of deposits, and treasury bills with a maximum maturity of 1 year. These funds have moderately low price sensitivity to interest rate changes but may be subject to credit risks depending on the credit quality of the underlying instruments.

Dynamic Bond Funds

Dynamic bond funds invest in debt instruments of varying maturities depending on their interest rate outlook. If the fund manager expects interest rates to fall, they will invest in longer-duration instruments to benefit from price appreciation. If they expect rates to rise, they will invest in shorter-duration instruments to get higher yields and reduce interest rate risk.

Corporate Bond Funds

Corporate bond funds invest a minimum of 80% of their total assets in corporate bonds with the highest ratings. These funds are good for investors with a lower risk tolerance seeking to invest in high-quality corporate bonds.

Gilt Funds

Gilt funds invest a minimum of 80% of their investible corpus in government securities across varying maturities. These funds do not carry any credit risk but have high sensitivity to interest rate changes.

Credit Risk Funds

Credit risk funds invest a minimum of 65% of their investible corpus in corporate bonds with ratings below the highest-quality corporate bonds. Therefore, these funds carry a degree of credit risk and offer slightly better returns than the highest-quality bonds.

Floater Funds

Floater funds invest a minimum of 65% of their investible corpus in floating-rate instruments. These funds carry a low interest rate risk.

Ultra-Short Duration Funds

These invest in money market instruments and debt securities so that the Macaulay duration of the scheme is between three and six months.

Short Duration Funds

Short duration funds invest in money market instruments and debt securities so that the Macaulay duration of the scheme is between one and three years.

Medium Duration Funds

Medium duration funds invest in money market instruments and debt securities so that the Macaulay duration of the scheme is between three and four years.

Long Duration Funds

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

Debt Mutual Fund Taxation

Debt mutual funds are investment instruments that predominantly invest their funds in fixed-income securities, such as bonds, treasury bills, corporate bonds, debentures, and other debt instruments. These funds are ideal for conservative investors who want to minimise market risks.

The taxation of debt mutual funds has undergone some changes in recent years. Previously, the taxation was based on the holding period rule, where short-term capital gains (sold within 36 months) were taxed at slab rates, and long-term capital gains (sold after 36 months) were taxed at 20% with an indexation benefit.

However, as per the latest updates, the indexation benefit on debt mutual funds has been scrapped, and now these funds will be taxed at the investor's slab rates, similar to fixed deposits. This change brings debt mutual funds at par with fixed deposits in terms of taxation. It is important to note that these changes are applicable for debt mutual funds purchased after a certain date, with different sources mentioning dates such as 1st April 2023 and 23rd July 2024.

Additionally, the definition of the holding period for debt funds has also been revised. Short-term capital gains tax now applies to debt funds held for less than 24 months, while long-term capital gains tax applies to those held for more than 24 months, for funds purchased before the aforementioned dates.

The removal of the indexation benefit means that investors can no longer adjust the purchase price of their debt mutual funds for inflation, resulting in a higher tax liability, especially if their returns are close to the Cost Inflation Index (CII).

It is worth noting that the tax implications for debt funds depend on the underlying investments. To qualify as a debt fund, a fund must hold at least 65% of its portfolio in bonds or money market instruments.

Debt Mutual Fund Risks

Debt mutual 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 well-suited for investors seeking a stable and predictable source of income and are generally considered low-risk. However, there are still some risks associated with debt mutual funds that investors should be aware of.

Firstly, debt mutual funds carry interest rate risk. This means that the prices of the debt instruments held by the fund have an inverse relationship with interest rates. When interest rates fall, the prices of bonds go up, which boosts the net asset value (NAV) of the debt mutual fund. Conversely, if interest rates rise, the value of existing bonds decreases as they offer lower interest rates than new bonds. This, in turn, leads to a fall in the NAV of the fund. While it is impossible to predict interest rate movements with certainty, investors can mitigate this risk by investing in funds that lend for short to medium-term periods, as interest rates typically do not change drastically over short periods.

Secondly, debt mutual funds carry credit risk, which is the risk that the borrower defaults on their payments. In such a scenario, the bonds issued by the borrower may become worthless, and investors in the mutual fund would incur losses. To minimise this risk, investors should opt for debt funds that lend to highly-rated corporates with strong credit ratings, indicating lower credit risk. However, it is important to note that higher-rated borrowers typically offer lower interest rates.

Additionally, while debt mutual funds are considered less volatile than equity funds, they are not entirely risk-free. The level of risk depends on the specific fund and its underlying investments. U.S. government debt is generally considered the least risky, while the risk associated with corporate debt depends on the company's credit rating. Investment-grade debt, issued by companies with high credit quality, is less risky than high-yield debt, which is issued by lower credit quality companies and offers higher returns but also higher potential risk.

Debt Mutual Fund Returns

Debt mutual funds are a type of investment fund that deals with fixed-income instruments. These funds generate returns by lending money to governments and companies, investing in corporate and government bonds, corporate debt securities, and money market instruments. The lending duration and type of borrower determine the risk level of a debt fund.

Debt mutual funds are ideal for investors seeking regular income with low risk. They are less volatile than equity funds and offer stable returns, high liquidity, and reasonable safety. Fees on debt funds are also lower than those on equity funds due to lower management costs.

When considering debt mutual fund returns, it is important to understand the return calculation measurements used as performance indicators. Debt funds involve income generation, and funds may pay scheduled monthly or quarterly dividends. Total return calculations account for these income payouts, while general return calculations may not.

The returns on debt mutual funds depend on interest payments and changes in interest rates. Interest payments from bond holdings generate coupon or accrual income for the fund. When interest rates change, bond prices move in the opposite direction, resulting in capital gains or losses on the fund portfolio. When market yields increase, bond prices decline, leading to a decrease in the fund's value. Conversely, when market yields fall, bond prices increase, driving up the fund's value.

The capital gain/loss component is also known as the mark-to-market (MTM) return. The type of bonds held by the debt fund determines how much it earns through interest and capital gains. Funds with a higher proportion of long-term bonds are more likely to experience capital gains or losses. These funds can make significant capital gains when interest rates are falling but may generate substantial losses when rates rise. On the other hand, funds that primarily invest in short-term securities, such as money market debt or treasury bills, have stable net asset values (NAVs) and do not benefit from capital gains.

To manage returns, debt funds adjust the maturity profile or credit rating of their bond portfolios. Holding AAA or AA+ debt ensures the safety of the principal but may result in minimal yields. Increasing exposure to lower-rated bonds can boost coupon income but also raises credit risk. Therefore, the best-performing debt funds carefully balance interest rate and credit calls to manage risk and deliver strong returns.

When investing in debt mutual funds, it is essential to consider factors such as taxes, investment tenure, liquidity, flexibility, stability, and credit quality ratings. While debt funds are considered low-risk, they are not risk-free and are subject to interest rate risk and credit risk.

Debt Mutual Fund vs Fixed Deposits

Debt Mutual Funds vs Fixed Deposits

A debt mutual fund is a mutual fund scheme that invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. Debt funds are also referred to as fixed-income funds or bond funds. Fixed-income instruments are investments that produce steady cash flows for investors, such as fixed-rate interest and dividends.

Fixed Deposits (FDs) are a more traditional form of investment, where investors put their money into bank FDs to earn interest while protecting their capital. FDs are considered a safe investment option, but in recent years, debt mutual funds have gained popularity due to their potentially higher returns and flexibility.

Returns

One of the main advantages of debt mutual funds over fixed deposits is the potential for higher returns. Debt mutual funds offer slightly higher returns than bank FDs, making them a more attractive option for investors. The returns on FDs are typically pre-set by banks based on the chosen tenure, while debt fund returns depend on the overall interest rate movement in the economy. During times of low-interest rates, debt funds can outperform FDs by a considerable margin.

Risk

Debt mutual funds are considered relatively low-risk investments. They are less volatile than equity funds and are, therefore, less risky. However, it is important to note that debt funds are subject to credit risk, interest rate risk, and reinvestment risk. On the other hand, FDs are generally considered a safer investment option, especially those from nationalised banks or sovereign-backed entities, which have little credit risk.

Flexibility

Debt mutual funds offer more flexibility than fixed deposits. Investors can choose between a Systematic Investment Plan (SIP) or a one-time investment. Additionally, debt funds allow for early withdrawal, usually after a small lock-in period, although this may be subject to exit loads. In contrast, FDs often levy a penalty for premature withdrawals, and withdrawing money before the due date typically requires breaking the entire FD.

Taxation

The taxation on debt mutual funds and fixed deposits differs. Short-term gains on debt funds (less than three years) are taxed as per the investor's tax slab rate. Long-term gains on debt funds (up to three years or more) are taxed at a lower rate, typically 20%, with the benefit of indexation. On the other hand, fixed deposit returns are taxed as per the investor's tax slabs.

Inflation Adaptability

Debt mutual funds have the potential to keep pace with inflation, despite the associated risks. For example, if the inflation rate is close to the interest rate on an FD, the adjusted return may be minimal. Debt funds may deliver relatively higher returns, helping to offset the effects of inflation.

In summary, debt mutual funds offer higher returns, more flexibility, and better inflation adaptability than fixed deposits. However, it is important to consider the risks associated with debt funds, such as credit and interest rate risk. The decision between investing in debt mutual funds or fixed deposits should be based on an individual's risk appetite, income tax slab, time horizon, and investment goals.

Frequently asked questions