Debt mutual funds are investment schemes that channel your money into fixed-income instruments like corporate and government bonds, corporate debt securities, and money market instruments. Due to this, they are also known as Fixed Income Funds or Bond Funds. Debt mutual funds are an excellent choice for those seeking a steady and relatively low-risk investment avenue. In this blog, we'll look into debt mutual funds in-depth understanding, how they work, and why they might be the perfect addition to your investment portfolio.
On the Bajaj Finserv platform, we have over 15 categories of debt funds depending on their maturity period. Invest in debt funds to get stable returns and diversify your investment portfolio.
The following sections of this blog will cover important details related to these funds.
What is a debt mutual fund?
A debt mutual fund is a type of investment vehicle that pools money from various investors and primarily allocates it to fixed-income instruments such as government securities, corporate bonds, treasury bills, and other debt-related securities. Its primary goal is to provide relatively stable returns and lower risk compared to equity funds. While not entirely risk-free, debt mutual funds are popular among conservative investors looking to preserve capital and generate moderate, predictable earnings.
How do debt funds work?
The fund manager of debt funds purchases listed or unlisted debt securities at a particular price. Then, he/she sells them later at a margin, which increases or decreases the fund’s value.
The underlying debt instruments in which the scheme invests also generate periodic interest. There are certain schemes, which earn more interest from fixed-income instruments during the fund's tenure. Interest income gets added to a debt scheme daily.
The Net Asset Value (NAV) of a debt scheme depends on the interest rates of underlying assets. It also depends on the upgradation or gradation of the credit ratings of a fund's holdings. Another factor affecting a debt fund's returns is interest rate movements.
Debt mutual funds are a great way to balance risk and returns in your portfolio. Whether you're a new or experienced investor, exploring different fund options can help you make informed decisions.
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Features of debt mutual funds
While once of the most prominent feature of debt mutual fund is that they have a capability of providing a fixed income, here are some other features as well:
Feature |
Explanation |
Investment in Fixed-Income Securities |
Debt funds primarily invest in fixed-income securities such as government bonds, corporate bonds, and treasury bills. These securities provide regular income in the form of interest payments. |
Predetermined maturity dates |
Debt instruments held by debt funds have predefined maturity dates, indicating when the principal amount will be repaid to investors. This characteristic ensures predictability in cash flows. |
Stability of Returns |
Returns from debt funds are relatively stable and less susceptible to market volatility compared to equity funds. The fixed-income nature of the underlying securities helps mitigate risk. |
Diversification benefits |
Debt funds offer diversification benefits by investing in a range of debt instruments with varying maturities, credit ratings, and issuers. This diversification helps spread risk across different assets. |
Low to Moderate Risk |
Debt funds are generally considered low to moderate risk investments due to the stability of fixed-income securities and the diversified nature of the portfolio. They are suitable for investors seeking steady returns with lower risk exposure. |
Liquidity |
Debt funds typically offer liquidity to investors, allowing them to buy or sell fund units at prevailing market prices. However, the liquidity may vary depending on the type and maturity of the underlying securities. |
Types of debt funds
There are many different types of debt mutual funds in India. Here are a few unique types:
- Liquid funds
These are highly liquid debt funds. These schemes invest in debt instruments, which have a maturity period of 91 days. One can withdraw a maximum of Rs. 50,000 as an instant redemption facility from certain schemes. Experienced investors consider liquid funds to be the least risky investment option. - Dynamic bond funds
Debt mutual funds where the fund manager can decide the investment portfolio’s duration are known as dynamic bond funds. Generally, dynamic bond funds have a fluctuating maturity period because their underlying instruments can have short or long maturity periods. These funds carry more risk than short-term debt funds.
- Fixed maturity plan (FMP)
The most important feature of this category of debt schemes is it comes with a lock-in period, which varies depending on the chosen scheme. One can invest in these schemes only during their initial offer periods. - Corporate Bond Fund
This fund allocates at least 80% of its total assets to the highest-rated corporate bonds. These funds are suitable for those who want to invest in high-quality corporate bonds but have a reduced risk tolerance.
- Bank and PSU Fund
Places at least 80% of its assets in debt instruments issued by banks and PSUs (public sector undertakings).
- Gilt Fund
places government securities of various maturities at least to the extent of 80% of its investible corpus. Credit risk does not exist with these funds. The danger associated with interest rates is substantial.
Why invest in debt mutual funds
You should consider investing in debt mutual funds for the following reasons:
- Liquidity: Debt mutual funds offer high liquidity to the investor. You can redeem your debt fund investment easily when in need of urgent cash. Unlike traditional investment instruments like FDs and tax-saving ELSS funds, debt funds do not come with a mandatory lock-in period. However, some debt funds may impose a nominal exit load if on redemptions made before a specific time period (usually 1 year).
- Lower risk: Debt-oriented funds invest in fixed-income securities and are less volatile than equity funds. Diversifying your portfolio with debt fund investments ensures potentially stable returns. Systematically investing in debt funds can help you capitalise on short-term opportunities while minimising overall portfolio risk.
- Diverse investment options: When you decide to invest in debt funds, you can choose from a variety of fund options, including short-term, overnight, liquid, and corporate bond funds. Fund types vary across the maturity and credit risk scale. Therefore, you can select a debt fund that best aligns with your investment goals, time horizon, and risk comfort.
- Professional management and good returns: Debt funds are managed by experienced fund managers who allocate your money to maximise returns. Debt funds allow you to invest in money markets and wholesale debt markets with the help of expert professional management. Moreover, investing in debt funds allows you to earn both interest income as well as capital gains. Debt funds tend to yield higher returns when compared to traditional instruments like FDs.
Whether you are investing for short-term liquidity or long-term stability, debt mutual funds provide a reliable investment avenue. Ready to start your journey
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How to pick the right debt fund?
Choosing the right debt funds can be a time-consuming task. Ensure you evaluate the following factors when selecting debt funds for your portfolio:
- Carefully evaluate your financial objectives underpinning this investment. In other words, distil the purpose of your investment. Understand whether you are investing for post-retirement income, to meet liquidity needs, or to build a contingency fund. Choose the funds that best align with your goals.
- Ensure that your fund choice matches with your investment duration. For instance, consider liquid and ultra-short-term debt funds for short-term goals that you plan to achieve in a year or sooner. For medium-term goals that are 3-5 years away, you can opt for dynamic or corporate bond investments.
- Debt funds are low-risk MFs but are not completely risk-free. Therefore, you should consider and understand the credit and interest rate risk associated with your investment. For instance, you should check the credit rating of the fund’s underlying securities and choose those with a high credit rating to minimise default risk.
- Review the historical performance of the debt fund. It helps you understand how the fund performs under changing market conditions and fluctuating interest rates.
- Assess the expense ratio of the fund. A high expense ratio can reduce your total returns. Since debt funds already offer lower returns, a high expense ratio can further lower your returns.
- Understand how debt funds are taxed in India. If you sell a debt fund within 2 years, a short-term capital gains tax will apply to your earnings as per the applicable income tax slab rate. However, if you sell a debt fund after 2 years (24 months), a long-term capital gains tax of 12.5% will apply to your earnings.
Who should invest in a debt fund?
People with a low risk-taking capacity are the ideal investors of debt funds. These schemes suit the following investors:
- Short-term investors
People who have an investment horizon of 3 to 12 months can consider investing in debt funds. It is a much better option than keeping funds in a regular savings account. They can consider investing in liquid funds that offer returns of around from 6 to 7%, annually. - Medium-term investors
People who have a medium-term investment horizon of 3 to 5 years can choose debt schemes. For such investors, dynamic bond funds are suitable as they generate higher returns than fixed deposits and short-term bond funds. If an individual wants monthly payouts, they can choose a monthly income plan.
How to Invest in Debt Mutual Funds?
Investing in debt mutual funds can be a relatively straightforward process once you understand the basic steps involved. First, identify your financial goals and risk tolerance. Debt funds typically suit conservative investors aiming for stability and moderate returns over short to medium horizons. Next, research different debt fund categories, such as liquid funds, ultra-short duration funds, short-term funds, or corporate bond funds, each designed for specific investment tenures and risk preferences. Compare the performance history, expense ratio, and credit quality of the underlying instruments. Many investors also examine ratings from agencies like CRISIL for added reassurance.
Once you’ve chosen a suitable fund, open an investment account if you don’t already have one—this can be done through a trusted advisor, online brokerage platform, or your bank’s mutual fund portal. Complete the Know Your Customer (KYC) process if necessary. Finally, decide on a systematic investment plan (SIP) or lump-sum contribution based on your cash flow. Regularly monitor your debt funds and rebalance as needed, particularly if your financial needs or market conditions change.
Debt Mutual Funds Taxation
If you possess the scheme units for a duration of three years or less, the gains are classified as short-term capital gains (STCG). These STCG are integrated into your taxable income and taxed according to the applicable income tax slab. On the other hand, if you retain the scheme units for over three years, the resulting gains are termed long-term capital gains (LTCG). LTCG is subject to a 20% tax rate, offering the advantage of indexation benefits. This tax structure provides investors with clarity on how the holding period influences the tax treatment of capital gains in accordance with the prevailing regulations.
Benefits of Investing in Debt Mutual Funds
- Steady Returns: Debt funds generally invest in fixed-income securities, offering predictable and relatively stable returns compared to equity-based instruments.
- Lower Risk: By focusing on bonds and government securities, debt mutual funds typically carry less volatility and market fluctuation.
- Diversification: These funds spread investments across various debt instruments, reducing the impact of any single security’s performance on overall returns.
- Liquidity: Most debt funds allow easy redemption, providing quick access to your money whenever you need it.
- Flexibility: Numerous categories, such as liquid funds for short-term needs and corporate bond funds for moderate durations, let you align your investments with specific goals.
- Professional Management: Experienced fund managers handle asset selection and portfolio adjustments, saving you the time and effort of individual bond research.
- Tax Efficiency: Over certain holding periods, capital gains on debt funds may receive favorable tax treatment compared to interest earned on fixed deposits.
Risks associated with Debt Funds
While debt funds offer a degree of independence from stock market fluctuations, they are not without risks. The various risks associated with debt funds are detailed below:
- Credit Risk: The likelihood that the issuer of debt instruments may fail to repay the principal and interest.
- Liquidity Risk: The risk that a fund may lack adequate liquidity to meet investor redemption requests.
- Interest Rate Risk: The impact on the fund's Net Asset Value (NAV) due to a drop in the price of debt instruments when interest rates rise.
- Market Risk: Specific risks associated with certain types of debt funds, such as dynamic bond funds, where portfolio adjustments based on interest rate changes can lead to losses if decisions are incorrect.
- Returns on Debt Funds: Despite offering lower returns compared to equity schemes, debt funds have the potential for higher returns than traditional bank fixed deposits or savings accounts. However, returns are not guaranteed due to various risks.
Investors seeking higher returns without venturing into traditional equity schemes can consider allocating funds to an index fund.
List of debt mutual funds in India
- Aditya Birla Sun Life Medium Term Plan Fund
- UTI Medium to Long Duration Fund
- HDFC Regular Savings Fund
- Sundaram Low Duration Fund
- ICICI Prudential Gilt Fund
- Sundaram Short Duration Fund
- UTI Short Duration Fund
- ICICI Prudential Gilt Fund
- UTI Ultra Short Duration Fund
- ICICI Prudential All Seasons Bond Fund
How Debt Funds Are Different from Other Mutual Fund Schemes?
Debt funds differ from other mutual fund schemes primarily by investing in fixed-income instruments instead of equities or a balanced mix of assets. Equity mutual funds, for instance, focus on stocks and are generally more volatile, with returns tied to market fluctuations. On the other hand, debt funds aim for steadier returns and lower price swings, making them suitable for conservative investors or those with shorter investment horizons.
Moreover, debt funds typically prioritize capital preservation and modest, predictable gains, whereas equity funds target higher growth potential but come with greater risks. Hybrid or balanced funds combine both debt and equity, offering a middle ground with moderate risk and return profiles. Another key difference lies in the underlying portfolio composition. Debt funds may hold government bonds, treasury bills, corporate papers, and other fixed-income instruments, which have varying credit ratings. By focusing on these instruments, debt funds tend to be less influenced by stock market volatility, providing a potentially safer harbor for risk-averse investors.
Things to consider before investing in debt mutual funds
Before investing in debt mutual funds, there are several important factors to consider. These include:
- Investment Objective: Clearly define your investment goals. Are you looking for regular income or capital appreciation? Your objective will influence the type of debt funds you should invest in.
- Risk Tolerance: Assess your risk tolerance. Debt funds are generally considered less risky than equity funds, but they still carry some level of risk, primarily related to interest rate movements and credit quality. Choose funds that align with your risk tolerance.
- Investment Horizon: Determine how long you intend to invest. Short-term, medium-term, and long-term debt funds are available. Your investment horizon will help you select the appropriate category.
- Credit Quality: Check the credit quality of the securities held by the debt fund. Higher-rated bonds are generally safer but may offer lower yields, while lower-rated bonds carry more risk but can provide higher returns.
- Expense Ratio: Compare the expense ratios of different funds. Lower expenses can have a significant impact on your overall returns over time.
- Exit Load: Be aware of any exit loads or penalties for early redemptions. Some funds may charge a fee if you redeem your investment before a specified period.
- Liquidity Needs: Consider your liquidity requirements. Debt funds offer better liquidity than fixed deposits, but some may still have a short exit load or redemption period.
- Tax Implications: Understand the tax implications of debt fund investments. Short-term and long-term capital gains are taxed differently.
- Fund Manager's Track Record: Research the fund manager's track record in managing debt funds. A skilled and experienced manager can make a significant difference.
- Diversification: Diversify your investments across different types of debt funds to spread risk. Don't put all your money in a single fund.
- Economic and Interest Rate Outlook: Stay informed about the economic and interest rate environment. Changes in interest rates can impact the performance of debt funds.
- Fund House Reputation: Choose debt funds from reputable and well-established fund houses with a history of good governance and investor-friendly practices.
Now that you understand debt mutual funds, the next step is selecting the right fund to match your financial objectives. Explore and invest wisely.
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By considering these factors and conducting thorough research, you can make more informed decisions when investing in debt mutual funds.
Key takeaways
- Debt mutual funds invest primarily in fixed-income securities like bonds, government securities, and corporate debt, making them a relatively stable investment option.
- These funds are less volatile than equity funds and are suitable for investors seeking steady returns with lower risk.
- Types of debt funds include liquid funds, ultra-short duration funds, short-term funds, and gilt funds, each catering to different investment horizons and risk appetites.
- Taxation on debt mutual funds is based on holding period—gains from investments held for more than 3 years earlier qualified as LTCG, but post-2023, they are taxed as per the investor’s income slab.
- Ideal for conservative investors aiming for capital preservation and predictable returns.
Conclusion
In conclusion debt funds offer investors a prudent avenue to diversify their portfolios while mitigating risk. By allocating capital into fixed-income securities such as government bonds, corporate bonds, and treasury bills, debt funds provide a stable source of income with relatively low to moderate risk exposure. The predetermined maturity dates and stability of returns make debt funds an attractive option for investors seeking steady income streams and capital preservation. Furthermore, the flexibility, liquidity, and tax efficiency of debt funds enhance their appeal among a wide spectrum of investors. As financial markets continue to evolve, debt funds remain a resilient and indispensable component in achieving long-term financial objectives while navigating the complexities of investment landscapes.
