What are Debt Funds?
Debt Mutual Funds invest in fixed income instruments like Corporate Bonds, Government Bonds and Money Market instruments.
These instruments are issued by banks, financial institutions, corporates, municipalities, and government
(state and central). These instruments are issued to raise money to finance a variety of projects and activities.
Why Invest Debt in Funds?
Diversification is essential to mitigate risk. An equity-heavy portfolio will suffer a huge drawdown when markets correct. On the other hand, a portfolio having an optimal balance between equity and debt could protect the downside better.
As part of the asset allocation process, investors should invest across different asset classes to cut down risk and achieve an optimal balance between risk and reward.
Relationship between Bond prices and Interest Rates
Bond prices and interest rates have an inverse relationship. As interest rates rise, bond prices fall and vice-versa. Why does this happen? Suppose a bond today pays a coupon of 6%.
If interest rates rise to 7%, investors will now start flocking to new bonds which are paying 7%, thereby reducing demand for old bonds. Thus, the prices of existing bonds paying 6% fall as these bonds lose their attractiveness.
Thus, it is advisable to invest in short term bonds when the interest rates in the economy are set to rise. When rates rise, short term and ultra-short term funds can reinvest in new bonds paying higher coupons when interest rates rise. On the other hand, when interest rates are set to decline,
it is advisable to invest in long term bonds or gilt securities as one can lock in the high rates and can also look forward to generating some capital appreciation.
How are Debt Funds Taxed?
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Long-Term Capital Gains: Gains arising out of investments sold after three years are taxed at 20% with indexation benefit. Applicable for investments made till March 31, 2023. Gains arising out of investments made from April 1, 2023, are taxed as per your slab rate. Long term capital gains tax and indexation benefit will no longer be available for such investments.
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Short-Term Capital Gains: Gains arising out of investments sold before three years attract short-term capital gains tax at your slab rate.
Debt Funds offer indexation benefits (for long-term capital gains tax) which effectively reduces the capital gain and the tax outgo. Cost Inflation Index is used to calculate the inflation-adjusted prices of assets.
Here’s an illustration of Rs 1 lakh invested for 3-year plus horizon which has grown to Rs 1.20 lakh at the time of redemption.
The investment value (Rs 1 lakh) is adjusted for inflation by taking the corresponding values from the table above from the purchase year 2018 (272) and sale year 2021 (301) from Cost Inflation Index.
As we can see, the tax outgo reduces from 4,000 to 1,868 if we apply indexation.
Benefits of Debt Funds
Low Cost: All mutual funds charge an expense ratio which is utilized to manage the scheme’s cost.
The expense ratios are capped and regulated by the Securities and Exchange Board of India (SEBI). The TER is charged based on the size of the fund, category and strategy. For instance, the TER of actively managed funds will be more than that of passively managed funds.
Liquidity: You can redeem your investments from open-ended funds at any time. Thus, Debt Funds can be used to save for any emergency or short-term goals.
Safety: Debt Funds come with varying degrees of risk based on the underlying portfolio of issuers' Credit Rating (Credit Risk) and movement of interest rates (Interest Rate Risk). Risk-averse investors may consider Overnight, Liquid, Ultra Short Duration Funds.
Types of Debt Funds
There are 16 categories of Open Ended Debt Funds. They are:
- Overnight Fund: These are open-ended debt funds that invest in overnight securities having a maturity of 1 day. These funds carry relatively Low Risk and provide high liquidity. These funds can be used to park idle surplus funds for very short term
- Liquid Fund: These funds invest in debt and money market securities with maturity of up to 91 days. They carry Low to Moderate Risk and can be used to manage short term liquidity requirement
- Ultra Short Duration Fund: These funds invest in debt and money market instruments such that the Macaulay duration of the portfolio is between 3 months to 6 months. These funds carry Low to Moderate Risk. Macaulay duration is the weighted average term to maturity of the cash flows from a bond.
- Low Duration Fund: These funds invest in debt and money market instruments such that the Macaulay duration of the portfolio is between 6 months to 12 months. These funds carry Low to Moderate Risk.
- Money Market Fund: These funds Invest in Money Market instruments having a maturity of up to 1 year. These funds carry Low to Moderate Risk and ideal for investment horizon of 6 to 12 months.
- Short Duration Fund: These funds invest in debt & money market instruments such that the Macaulay duration of the portfolio is between 1 year to 3 years. These funds carry Low to Moderate Risk. Investors with more than 12 month time horizon can look at investing this category.
- Dynamic Bond:These funds invest across duration. Ideal for investors with 3-year plus investment horizon. These funds carry relatively High Interest Rate Risk and Moderate Credit Risk.
- Corporate Bond Fund: These funds predominantly invest in AA+ and above rated corporate bonds. These funds carry relatively high Interest Rate Risk and Moderate Credit Risk.
- Banking and PSU Fund: These funds invest a minimum of 80% of total assets in debt instruments of Banks, Public Sector Undertakings, Public Financial Institutions, and Municipal Bonds. These funds carry a relatively High Interest Rate Risk and Moderate Credit Risk.
- Gilt Fund: These funds invest a minimum of 80% of total assets in central and state government securities across maturities. These funds carry a relatively High Interest Rate risk and Moderate Credit Risk.
- Gilt Fund (10-year constant duration): These funds invest a minimum of 80% of total assets in government securities, such that the weighted average portfolio maturity of the portfolio is equal to 10 years. These funds carry relatively High Interest Rate Risk and Relatively Low Credit Risk.
- Floater Fund:These funds invest a minimum of 65% of total assets in floating rate instruments, including fixed rate instruments converted to floating rate exposures using swaps/ derivatives. These funds carry High Interest Rate Risk and Moderate Credit Risk.
- Medium Duration Fund:These funds invest in debt & money market instruments such that the Macaulay duration of the portfolio is between 3 years to 4 years. These funds carry relatively High Interest Rate risk and Relatively High Credit Risk.
- Medium to Long Duration Fund: These funds invest in debt & money market instruments such that the Macaulay duration of the portfolio is between 4 years to 7 years. These funds carry relatively High Interest Rate risk and Relatively High Credit Risk.
- Long Duration Fund: These funds invest in debt & money market instruments such that the Macaulay duration of the portfolio is greater than 7 years. These funds carry High Interest Rate Risk and Relatively Low Credit Risk.
- Credit Risk Fund:These funds invest a minimum of 65% of total assets invest in AA and below rated corporate bonds (excluding AA+ rated corporate bonds). These funds carry relatively High Interest Rate Risk and relatively High Credit Risk.
Close Ended Debt Scheme
Close Ended Schemes are listed on the stock exchanges after the New Fund Offer (NFO) period. Fixed Term Plan or Fixed Maturity Plan is a type of close ended scheme which invest in securities whose maturity matches the tenor of the fund. This helps in locking in the yield which eliminates interest rate risk. Post NFO, investors can buy or sell the fund only on the stock exchanges.