What Are Debt Funds and How Do They Work?

Buying a debt instrument can be considered as lending money to the entity issuing the instrument. A debt fund invests in fixed-interest generating securities such as corporate bonds, government securities, treasury bills, commercial paper, and other money market instruments. The fundamental reason for investing in debt funds is to earn a steady interest income and capital appreciation. The issuers of debt instruments pre-decide the interest rate you will receive as well as the maturity period. Hence, they are also known as ‘fixed-income’ securities.

How Do Debt Funds Work?

Debt funds invest in a variety of securities, based on their credit ratings. A security’s credit rating signifies the risk of default in disbursing the returns that the debt instrument issuer promised. The fund manager of a debt fund ensures that he invests in high rated credit instruments. A higher credit rating means that the entity is more likely to pay interest on the debt security regularly as well as pay back the principal upon maturity.

Debt funds which invest in higher-rated securities are less volatile when compared to low-rated securities. Additionally, maturity also depends on the investment strategy of the fund manager and the overall interest rate regime in the economy. A falling interest rate regime encourages the fund manager to invest in long-term securities. Conversely, a rising interest rate regime encourages him to invest in short-term securities.

Who Should Invest In Debt Funds?

Debt funds try to optimize returns by investing across all classes of securities. This allows debt funds to earn decent returns. However, the returns are not guaranteed. Debt fund returns often fall in a predictable range. This makes them safer avenues for conservative investors. They are also suitable for people with both short-term and medium-term investment horizons. Short-term ranges from three months to one year, while medium-term ranges from three years to five years.

• Short-term debt funds

For a short-term investor, debt funds like liquid funds may be an ideal investment, compared to keeping your money in a saving bank account. Liquid funds offer higher returns in the range of 7%-9% along with similar kinds of liquidity to meet emergency requirements.

• Medium-term debt funds

For a medium-term investor, debt funds like dynamic bond funds are ideal for riding the interest rate volatility. When compared to 5-year bank FDs, debt bond funds offer higher returns. If you are looking to earn a regular income from your investments, then Monthly Income Plans may be a good option. Investing in debt funds is ideal for risk-averse investors as they invest in securities that offer interest at a predefined rate and return the principal invested in full upon maturity.

Things To Consider As An Investor

• Risk

Debt funds suffer from credit risk and interest rate risk, which makes them riskier than bank FDs. In credit risk, the fund manager may invest in low-credit rated securities which have a higher probability of default. In interest rate risk, the bond prices may fall due to an increase in the interest rates.

• Return

Even though debt funds are fixed-income havens, they don’t offer guaranteed returns. The Net Asset Value (NAV) of a debt fund tends to fall with a rise in the overall interest rates in the economy. Hence, they are suitable for a falling interest rate regime.

• Cost

Debt fund managers charge a fee to manage your money called an expense ratio. SEBI has mandated the upper limit of expense ratio to be no more than 2.25% of the overall assets. Considering the lower returns generated by debt funds as compared to equity funds, a long-term holding period would help in recovering the money forgone through expense ratio.

• Investment Horizon

If you have a short-term investment horizon of three months to one year, then you may go for liquid funds. Conversely, typical tenures for short-term bond funds can be two years to three years. In case of an intermediate horizon of three to five years, dynamic bond funds would be appropriate. Basically, the longer the horizon, the better the returns.

• Financial Goals

You can use debt funds as an alternative source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive a pension.

• Tax on Returns

Capital gains from debt funds are taxable. The rate of taxation is based on the holding period, i.e., how long you stay invested in a debt fund. A capital gain made during a period of fewer than three years is known as a Short-Term Capital Gain (STCG). A capital gain made over three years or more is known as Long-Term Capital Gains (LTCG). Investors can add STCG from debt funds to his/her income. Here, the tax is as per the income slab. A fixed 20% tax after indexation applies for STCG from debt funds.

Conclusion

Dividends offered by all classes of mutual funds are taxed in the classical manner. They are added to your overall income and taxed at your income tax slab rate. Previously, dividends of up to Rs 10 lakh a year were made tax-free in the hands of investors. The classical way of taxation was introduced in Budget 2020. The rate of taxation of capital gains of debt funds depends on the holding period. If the holding period is shorter than three years, then such gains are called short-term capital gains. These gains are taxed at investors’ tax slab. Gains realized after a holding period of three years are termed long-term capital gains. These gains are taxed at 20% after indexation.

Also read- What You Should Know About Life Insurance?

Some Benefits Of Buying A Life Insurance Policy On The Internet