Debt mutual funds can be defined as fixed-income mutual funds that invest in securities such as government securities, corporate bonds, commercial papers, treasury bills, and other money market instruments. All of these instruments carry a pre-decided interest rate and maturity date. People invest in debt funds to receive a steady interest income and get appreciation on their capital. The returns on many of the above-mentioned instruments are generally more than the interest rates on bank fixed deposits.
How Does a Debt Fund Work
Every debt security carries a credit rating. It enables investors to get an idea about the issuer’s risk of default in paying returns as . Debt-fund managers use credit ratings to pick high-quality debt instruments. A higher credit rating indicates that a debt instrument is safer to invest in. Debt funds that invest in securities with higher credit ratings display less volatility. But, fund managers also select low-quality debt instruments. They use various factors to select securities. Sometimes, they take a calculated risk and invest in such instruments to earn higher returns. The economy’s overall interest rate regime also influences a fund manager’s investment strategy. A falling regime pushes fund managers to choose long-term debt securities. A rising regime encourages them to choose short-term securities.
Who Should Choose Debt Funds
Investors with a lower risk appetite are likely to choose debt funds. These funds diversify their investment by investing across various securities to optimise returns. This helps debt funds in earning returns. Although there is no guarantee for returns, debt funds usually give predictable returns. As a result, conservative investors consider them attractive.
They also work for individuals with medium-term and short-term investment horizons.
Short-term Debt Funds
The tenure of these funds ranges from three months to one year. Debt funds, such as liquid funds, can be an attractive investment opportunity for short-term investors. Instead of choosing a regular savings account to keep your money, you choose liquid funds that can offer up to 7%–9% returns. As the tenure is short, these funds also ensure that you have enough liquidity.
Medium-term Debt Funds
The tenure of these funds ranges from three years to five years. When an investor thinks of investing in a low-risk investment opportunity for 3–5 years, a bank fixed deposit is one of the first ideas that come to their mind. But, investment in a debt fund such as a dynamic bond fund for a similar period can offer higher returns than a 5-year bank fixed deposit. You can choose a Monthly Income Plan if you need regular income in the form of monthly payouts from your investment.
Types of Debt Funds
There are many types of debt funds. The maturity period of securities that they invest in is the main differentiating factor of debt funds. Following are the different kinds of debt mutual funds.
Liquid funds are debt funds that invest in money market instruments with a maximum maturity of 91 days. Liquid funds offer better returns than savings bank accounts and provide similar liquidity. Many mutual fund companies provide instant redemption on investments in liquid funds through unique debit cards.
These funds have a maximum maturity of one year and they invest in money market instruments. Money-market funds suit those investors who seek low-risk, short-term debt securities.
Dynamic Bond Funds
In a dynamic bond fund, the fund manager keeps altering the portfolio composition. These funds make investments in debt instruments with varying maturities, depending on the changing interest rate regime. This option suits investors with an investment horizon of three to five years and a moderate risk appetite.
Income funds invest mainly in debt securities with extended maturity periods. As a result, they are more than dynamic bond funds. Income funds’ average maturity period is around 5 to 6 years.
Corporate Bond Funds
These funds invest at least 80% of their total assets in corporate bonds with the highest ratings. They are suitable for investors with lower risk appetites and those who wish to invest in corporate bonds of high quality.
Banking and PSU Funds
A banking and PSU fund invests a minimum of 80% of total assets in debt securities of public sector undertakings (PSUs) and banks.
These debt funds invest in government securities, which carry a low-credit risk. These funds are suitable for fixed-income investors with a low-risk appetite, as the government rarely defaults on the credit through debt instruments.
Credit Risk Funds
A credit risk fund invests at least 65% of its inve amount in corporate bonds with ratings below that of the highest quality corporate bonds. These funds carry significant credit risk and hence, offer higher interest rates compared to the highest quality bonds.
A floater fund invests at least 65% of its inve amount in floating rate instruments.
Overnight funds invest in debt securities that have a maturity of one day. These funds are considered safe, with negligible interest rate risk and credit risk. Most overnight funds have their expense ratio below 1%.
Fixed Maturity Plans
These are closed-ended debt funds. They make investments in fixed-income securities such as government securities and corporate bonds. Every fixed maturity plan has a fixed horizon. Your money will be locked-in for this period.
Ultra-short Duration Funds
These funds invest in debt securities and money market instruments so that the scheme’s Macaulay duration ranges from three to six months. The Macaulay Duration can be defined as the period an investor would require to receive all his money invested in an instrument in the form of periodic interest and principal repayments. A debt fund’s Macaulay Duration is the weighted average Macaulay Duration of debt securities in the portfolio.
Low Duration Funds
It makes investments in debt securities and money market instruments so that the scheme’s Macaulay duration ranges from six to twelve months.
Similarly, there are other funds that invest in debt securities and money market instruments and differ from each other in terms of their Macaulay duration.
Short Duration Funds – One to three years.
Medium Duration Funds – Three to four years.
Medium to Long Duration Funds – Four to seven years.
Long Duration Funds – More than seven years.
Things to Consider
Debt mutual funds carry a higher risk than bank fixed deposits as they suffer from interest rate risk and credit risk. A debt fund carries credit risk when its fund manager invests in securities with low-credit ratings that have a higher risk of default. You may face interest rate risk when the value of the bond you hold falls owing to the increase in interest rates.
Debt funds do not give you returns. A debt fund’s net asset value (NAV) tends to decline with an increase in the overall interest rates.
The expense ratio is the fee charged by debt fund managers, calculated as a percentage of the fund’s overall assets, to manage the fund. As debt funds generate lower returns than equity funds, a high expense ratio can hamper your earnings. A long holding period helps in recovering the investment lost through expense ratio.
Taxation on Debt Funds
Capital gains from debt mutual funds are taxable. The rate of taxation depends on the holding period, i.e., how long you remain invested in a fund. A capital gain earned over a period of up to three years is called a short-term capital gain (STCG). A capital gain earn over a period of three years or more is called long-term capital (LTCG). Short-term capital gains are added to an investor’s taxable income and taxed according to the income tax slab applicable. A fixed tax of 20% after indexation is applicable on long-term capital gains.
P2P Lending – An Alternative to Debt Funds
To expand your portfolio, it is always a good idea to consider various investment opportunities. Diversifying your investments reduces your risk and maximises your rewards. You can always make investments in safer options such as fixed deposits and government bonds. But, the low single digit returns deter such investment prospects!
So, if you’re looking for high returns, one of the rapidly growing investment opportunities enabled by technology is P2P lending. P2P or Peer-to-Peer Lending is an investment product that allows you lend directly to borrowers through an online marketplace. Marketplaces such as LenDenClub ensure the placements of your investments goes to creditworthy borrowers in the form of loans while you earn interest on your investments.
LenDenClub’s Fractional Matchmaking Peer-to-Peer Plan (FMPP®) provides returns of up to 10 to 12% p.a.* on your investment. You can remain invested for different periods, ranging from one to five years. The platform hyper-diversifies your investment to reduce the chance of defaulting for you. You can start investing in this plan with as low as INR 10,000.
*P2P investment is subject to risks. And investment decisions taken by a lender on the basis of this information are at the discretion of the lender, and LenDenClub does not guarantee that the loan amount will be recovered from the borrower.