When a person lends/invests money with a person/organization via an agreement where he/she will be earning some interest, this kind of setup is called debt investment. Debt mutual fund invests in a pool of securities such as bonds, debentures, and so on.
What is a Debt fund?
A debt fund invests in fixed-income securities such as corporate bonds, government securities, treasury bills, commercial papers, and other money market instruments. A debt fund generates returns from 1. Interest generated from the securities held in the portfolio 2. Capital Gains accrued due to interest rate movements. The interest rate which you will receive and the maturity period is pre-decided by the debt fund issuers. Thus, debt funds are also known as ‘fixed income’ instruments.
How do Debt funds work?
Based on the credit rating of a debt fund, it invests in a variety of securities. The credit rating represents the risk of default involved in paying out the returns that the debt instrument issuer has promised. The higher the credit rating of the debt instrument, the lower the risk of defaulting on repayment.
There are two types of risk involved in debt funds:
- Credit risk
- Interest rate risk
It is the risk of default on a debt security. It represents the risk of the borrower failing to repay the money on maturity. Credit rating is a measure to gauge the extent of credit risk associated with a security. When the security with the highest credit rating goes to the market to borrow money, it will offer the lowest rate of interest. This is because the probability of defaulting on repayment is low. On the other hand, the security of a lower credit rating will offer higher returns as the chances of defaulting are lower.
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It is the risk emerging from fluctuating interest rates. Rising interest rates bring down the market value of securities. This means there will be a capital loss. When the interest rates go down, the market value of securities goes up. This signifies that capital gains are generated. The quantum of the risk depends on the duration (tenure) of holding the debt fund. The longer the duration, the higher the risk while the shorter the duration, the lower the risk. This means that a rising interest rate regime encourages investors to invest in short-term securities while a falling interest rate regime encourages them to invest in long-term securities.
Who should invest in debt funds?
Debt funds invest across various classes of securities to optimize returns. Though there is no guarantee for returns, debt funds returns are usually in an expected range. Therefore, low risk investors find debt funds a good option to invest. Debt funds are also suitable for investors who want to invest in short or medium term. Short-term span is usually from three months to one year whereas medium term span can be considered as three to five years.
Types of debt funds
Every investor has different investment needs depending on his/her financial situation, risk appetite, and investment objective. There are various types of debt mutual funds, that suit the needs of diverse investors.
In this category, the debt funds invest in securities that mature overnight. Hence, this kind of debt fund has no interest rate risk. Also, overnight funds invest in government securities so there is no credit risk present there. They are the safest debt funds, but their yield is the lowest. This category of debt funds is suitable for those who have an investment tenure of one week or less.
Liquid funds invest in debt and money market instruments such as commercial papers, treasury bills, certificates of deposits, and others which mature within 91 days. Liquid funds carry low-interest rate risk as their underlying instruments have short maturities. Nevertheless, liquid funds may have an exposure to credit risk depending upon the credit quality of the underlying securities.
Money market fund
According to SEBI, money market funds should invest in money market instruments such as commercial papers, treasury bills, certificates of deposits and more having a maturity of less than 1 year. These funds have moderately low-price sensitivity to interest rate changes. But these funds have an exposure to credit risk and its extent depends on the credit quality ratings of the underlying securities of the fund. These funds are apt for investors with moderately low-risk appetites. One-two year of investment tenures is needed to invest in these funds.
Short duration funds
These funds invest in instruments having maturities ranging from one to three years. As the securities have short tenors, interest rate risk is also low. The category usually keeps a good credit quality portfolio. For the credit risk extent check, one should check the credit quality of the securities held in the portfolio.
Corporate bond funds
According to SEBI’s mandate, these companies should invest at least 80% of their assets in the highest-rated companies. In terms of credit risk, these funds are relatively safer than credit risk funds. Also, safer than gilt funds or long-term debt funds that are highly sensitive to interest rate changes in the economy.
Credit risk funds
As per SEBI, these funds have to invest at least 65% of their portfolio in less than AA-rated securities. This means that these funds invest in securities of lower credit quality. As most of the holdings will be in lower credit paper, credit risk funds will be able to offer higher returns but also have higher credit risk.
Dynamic bond funds
These funds have the flexibility to invest across durations depending on their interest rate outlook. So, the fund manager keeps changing the portfolio composition as per fluctuations in the interest rate regime. Investors should consider at least 3 years or longer to invest in these funds. This category has a high sensitivity to interest rate changes. These funds have different average maturity periods as these funds take interest rate calls and invest in securities of longer as well as shorter maturities.
This type invests at least 80% of its assets in government securities. Hence, these funds have low credit risk. They can be short or long-duration funds depending on the maturity of their portfolio.
Fixed maturity plans
These are close-ended debt funds. These funds also invest in fixed-income securities such as corporate bonds and government securities. Your money gets locked in for a fixed period in all FMPs. This horizon can be in months or years. One can only invest during the initial offer period of the FMP.
Long duration funds
As per SEBI’s mandate, long-duration funds invest in debt and money market instruments such that Macaulay’s duration of the fund portfolio is greater than 7 years. Macaulay duration measures the weighted average of the time to receive the cash flows from a bond so that the present value of cash flows equals the bond price.
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Aspects to consider before investing in debt mutual funds:
Debt funds face 2 major risks- credit and interest rate risk.
There is no guarantee of returns in debt funds even though they are fixed income havens. If there is a spike in the interest rates, there is a fall in NAV (Net Asset Value) tends to fall, and vice-versa.
This is one of the important metrics to look at while investing in debt mutual funds. The expense ratio is the charge by debt fund managers to manage your money. While investing, it is important to look at schemes having a lower expense ratio. This can help you to bring up your returns.
It is very important to know your investment horizon while making an investment in debt mutual funds. If you want to invest for one week to three months, then you might go for liquid funds. If you want to invest for one to three years, then short-term funds are a good option.
Taxation for debt funds
Capital gains on debt funds are taxable. The tax rate depends on the holding period. A capital gain occurring by staying invested in a debt fund for less than 3 years is known as Short Term Capital Gain (STCG). On the other hand, staying invested in a debt fund for more than 3 years is called Long Term Capital Gain (LTCG).
STCG is added to the income tax slab and taxed as per your income tax slab. While LTCG is taxed at 20% after indexation benefits.
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