What is a Debt Fund?
Debt mutual funds invest in securities which generate fixed income like corporate bonds, treasury bills, government securities, commercial papers and many other money market instruments. As a buyer, you can earn a pre-decided fixed interest rate on the maturity of these instruments. The market fluctuation does not affect the returns of the investors. For this reason, debt funds fall under low-risk investment options.
Benefits of Investing in a Debt Mutual Fund?
Debt funds have many advantages, some of them are:
Stable Growth of Investment
Debt mutual funds invest in fixed income securities and capitalise on the steady income from these securities for growth. The fixed income securities offer regular interest and capital appreciation based on market conditions. Due to the regular and mostly steady stream of inflows, debt funds offer more stable growth than equity mutual funds.
Better Liquidity Than Other Debt Investments
When compared to other investment options, debt mutual funds schemes, especially liquid funds, have a high degree of liquidity. It is also seen as an alternative to fixed deposits since it is low risk and does not have a mandatory lock-in period. It also not has a long withdrawal time like a fixed deposit.
More Tax Efficient Than Traditional Investments
If you invest in a debt mutual fund for at least three years it becomes far more tax-efficient than many other debt investments like fixed deposits and bonds. The short-term gain occurs if the investment is liquidated (= withdrawn) within three years. Liquidation any time after three years or 36 months will generate a long-term capital gain.
Taxability of Income from Debt Mutual Funds
| TYPE OF CAPITAL GAIN | TAX RATE |
|---|---|
| SHORT-TERM CAPITAL GAIN | Slab rate as per annual income of the Financial year. (Added to the annual taxable income) |
| LONG-TERM CAPITAL GAIN | 20% with indexation |
| DIVIDEND DISTRIBUTION FROM THE FUND | 25%+ 12% surcharge +4% cess [or] 29.120% |
| MONTHLY INCOME DISTRIBUTION FROM THE FUND | Depending on when the Units are liquidated as per FCFS rule taxable at Slab Rates as per Taxable Annual Income [or] 20% with Indexation |
No TDS: Another benefit is that debt schemes are not affected by TDS, unlike fixed deposit which has a straight deduction of 10.3%.
Transfer Funds to Other Schemes
If you have invested in a debt fund scheme, you can transfer the money to an equity scheme or any other scheme, hassle-free. Such an option is not available to you in other investment schemes like fixed deposits.
What are the different types of debt funds?
Debt funds can be classified into following different types based on the maturity period:
| Fund Type | Money invested in… | Avg. maturity period for securities | Risk-Return & Liquidity |
|---|---|---|---|
| Liquid Fund | money market securities | Max. 91 days | Low & High |
| Money Market Fund | money market securities & ultra-short term debt | Max 1 year | Low & High |
| Dynamic Bond Fund | debt instruments, i.e. corp. and gilt bonds, | Different maturities based on the market interest rate scenario | Medium & Low |
| Corporate Bond Fund | safe corporate bonds | Between 1 to 4 years | Medium & Low |
| Gilt Fund | mostly govt. securities and AAA rated corporate debt | 3 years or more | Low & Low |
| Credit Risk Fund | at least 65% of the corpus in BBB rated corporate bonds. | Between 3 to 5 years | High & Low |
| Overnight Fund | debt securities having a maturity of 1 day | 1 day | Low & High |
Liquidity here only refers to the possibility of withdrawing your investment out of the fund without incurring charges. Funds with low liquidity may discourage early withdrawals and apply additional charges on them.
How do Debt Mutual Funds Work?
Like any mutual fund, debt funds too collect money from thousands of investors and allocate units to them at NAV. (See more in “How Does Mutual Fund Work?”)
The only difference from other mutual funds is that debt funds will use the collected money (Asset Under Management) to buy debt securities from the secondary debt market. This segment of the market is called Wholesale Debt Market, and for India, it is dominated heavily by Govt. securities.
Debt funds may invest in fixed income securities slightly differently depending on the structure of the scheme:
Fixed Maturity Plans
FMP or Fixed Maturity Plans have a fixed maturity period, which can range between 3 years to 5 years and sometimes even longer. Based on the tenure of the FMP, the fund manager will invest in the debt securities such that all the instruments mature around the same time as the FMP. FMPs are, thus, somewhat immune to the interest rate risk as well as they won’t trade in the securities they hold. But, at the same time, long-duration FMPs may also miss the opportunities.
Unlike open-ended debt funds, FMPs will only accept investors within particular subscription dates and then lock-in the money till maturity. Thus, FMPs are less liquid as well. You may only sell the units back to the fund house in case you need an emergency exit.
Open-Ended Debt Funds
The open-ended scheme allows you to enter and exit at any time. Open-ended funds are also very active in trading debt securities and try to maximize their earnings by riding the capital gain wave, as well apart from the interest receipts.
The returns are generated in the following two forms (similar incomes but influenced by different reasons):
- Coupon or Interest receipts
- Capital Appreciation
Coupon & Interest Receipts
All bonds and debt securities, except ‘zero-coupon bonds,’ pay a fixed interest on a regular interval. Liquid funds and ultra-short-term debt funds may be an exception to this growth formula. For details see: “How Does Liquid Mutual Fund Work?”
For example, a bond you can buy at Rs. 931 today (face value Rs. 1000) may pay a quarterly interest based on its coupon rate. So, if the coupon rate on the bond is 5% payable quarterly, you will receive Rs. 12.5 for every such bond you have invested in.
So the regular coupons are one way of earnings from bonds and fixed income securities. Another way is capital appreciation.
Capital Gain in Bonds
A bonds market value may increase for a number of reasons. But it only happens before maturity.
As the bond’s maturity approaches, it’s market value inches closer to its face value. The market value of the bond may vary based on the following factors:
- The prevailing interest rate in the market
- Issuing firm growing on the credit rating scale
- Demand for the bond rising due to any other factor
While theoretically, as the RBI plays with the repo rates and reverse repo rates, bonds may see a variation in their market value. The logic behind this shakeup is called ‘opportunity cost’.
Imagine you hold a bond which promises to pay a coupon of 10% p.a. for the next five years. Next day RBI reduces the repo rate and now the new investors can only get about 8% p.a. on their investments. Naturally, your bonds are more valuable now since they pay a higher rate of interest.
Debt fund managers can take advantage of this situation on the bonds they hold and liquidate them to cash in the capital gain.
Are debt mutual fund risk-free?
Debt funds are not risk-free. However, debt funds are a much safer option than any equity funds. As mentioned above, the return on debt securities may vary due to certain factors. It’s a no brainer that the same factors would affect the funds holding a bunch of these securities.
Risks in Debt Funds
Typical risks a debt funds carries could be any of the following three types. But, each fund depending on the type of security it holds may carry a different degree of each of these risks:
Credit or Default-Risk
Under this, the issuers of the bonds may not pay the principal and interest. Of all the risks, this is the most dangerous one because ‘a default’ can cause permanent loss of capital.
Interest Rate Risk
In a dynamic market prevailing interest rates an investor can safely earn keeps on changing. Thus, the prices of bonds and the opportunity cost of holding them could change over time making them less valuable and dragging the fund’s NAV down.
Liquidity Risk
is the risk carried by the fund house of not having adequate liquidity to fulfil the redemption request of the investor.
How to Evaluate Risk in Debt funds?
The Fund Managers
When you are looking to invest in debt funds, make sure you are picking a good fund where the fund managers have clean track record of defaults. Studying fund managers won’t be an easy task for you so you can study the rating given by credit rating agencies. The top-rated funds are labelled as AAA then comes AA which is slightly lower and it goes on till D.
The NAV Trend
You can check the risk associated with the fund by checking the NAV growth of the last 5 years. If you see a stable and a uniform growth then you can conclude that there is no major credit event which affected the fund.
Significant Redemptions
If there is significant redemption in the fund then the fund may have to shut down in the near future and stop investors from redeeming.
Average Duration of Fund’s Securities
It is recommended that you match the time frame of your investment with the average duration of the securities the fund is holding. If you do so, the interest rate volatility can be evened out and you can expect return close to Net YTM (Yield To Maturity).
What does Fund SID Tell You?
Scheme Information Document or SID tells you what the scheme is all about, what is its objective, what it will do and how and where it will invest. SID can overload you with the information it carries, so you can focus on the important sections in SID.
You would want to focus on the following are the information in the SID:
- Indicative Asset allocation: which gives you the investment strategy of the fund.
- Fund Manager: The SID lists the fund managers and its co-fund managers along with their past experiences and qualifications.
- Tax Implication: You should check for tax implication on realized profits and dividends.
- Redemption Limit and Minimum Investment: Under this section, you should look for the minimum investment and redemption limit of the scheme.
How do you choose/evaluate debt mutual funds?
Below are the parameters you need to consider to evaluate the debt mutual funds:
- Investment Period: You need to decide your investment horizons, the period you want to stay invested. The debt funds offer you the option to invest for a day and also for 10-20 years. Based on your investment period, you can shortlist the funds you want to invest in. If you have an investment horizon of three years, it is always better to choose a fund with lower redemption expenses, so that you do not lose the earnings during early withdrawals.
- Risk Appetite: The risk varies from fund to fund and investor to investor, so you need to know your risk appetite. Overnight funds and liquid funds carry the least amount of interest rate risk, a gilt fund features the least amount of credit risk.
- Interest Rate Scenario: It is wiser to invest in short duration funds when there is an uptrend in interest rates. This is because, with increasing interest rates, the modified duration of long duration debt funds will be higher.
- Expense Ratio: This is an important parameter for you to consider before investing in debt funds. It is an annual maintenance charge charged by a fund house to manage its expenses like operating cost allocation charges, management fees, etc. Since the returns in debt funds are not on the higher side, a high expense ratio can dent your earnings. You should always look for schemes with lower expense ratios.
References:
- Return on Debt Funds – Moneycontrol.com
- Fund Deployment by Mutual Funds – SEBI Stats
- Debt Funds Risk & Return – AMFI
- Working of Debt Mutual Funds – Value Research
