Mutual Funds – Debt
Welcome to the next chapter of our introduction series on investment options.
Today, we take a look at Debt Mutual Funds.
Before we do so, here are our recommended brokers who can help you invest in mutual funds. We suggest you check each one and try at least 2 of them for a few months before you pick one platform for all your investments.
What are Debt Mutual Funds?
Debt mutual funds refer to funds that invest in fixed-income securities like bonds and treasury bills. Debt funds are designed for individuals who are not willing to invest in riskier equity markets. A debt fund provides a steady but low income relative to equity.
Types of Debt Mutual Funds
Gilt Mutual Fund
As the name suggests, these funds invest in Gilt or government debt securities. These funds invest in bonds and fixed interest-bearing securities issued by the state and central governments.
The government securities are issued by the Reserve Bank of India to raise money for the government, and these are bought by the Gilt Funds. Since the portfolios of these mutual funds are backed by the RBI, investing in a Gilt Fund is usually the safest option when it comes to mutual fund investments.
Monthly Income Plans (MIPs)
Monthly Income Plans are debt-oriented mutual funds that invest around 70-90% of the fund corpus in debt. These funds provide income in the form of interest payout every month.
These have low entry and exit loads which means the charges or fees you will pay at the time of investment and exit is quite less when compared to other funds.
There are two types of MIPs: dividend-oriented and growth-oriented. Even though MIPs do not guarantee regular returns, most well-managed MIPs are able to generate regular income for investors.
Overnight Funds
These funds invest in debt securities having a maturity of 1 day. They are considered to be extremely safe since both credit risk and interest rate risk is negligible due to the very short duration.
Liquid Funds
These funds invest in debt instruments with a maturity period of not more than 91 days. The core objective of the fund is to invest in liquid assets that provide capital protection and liquidity to investors. The short maturity period means the funds are not as affected by fluctuations in the interest rates as other long-term debt investments.
Money Market Fund
These funds invest in money market instruments that have a maximum maturity period of 1 year. These funds are preferred by investors seeking low-risk debt securities for the short-term.
Ultra Short Duration Funds
These are debt funds that invest in debt instruments with a maturity period of less than a year. The definition of the fund refers to them as funds with investments having a Macaulay duration of between 3-6 months.
Note: Macaulay duration refers to the time the funds will take to regain their investment amount. This means that if a fund has a Macaulay duration of between 3-6 months (like for Ultra Short Duration Funds), they are likely to invest for a longer period so the investors get good returns.
They are low-risk funds due to the shorter duration but rank slightly higher than liquid funds in terms of risk.
These funds usually have an exit load that may lower your returns.
Low Duration Funds
Low duration debt funds come with a Macaulay duration of 6-12 months. All funds which expire in 1-3 years are categorised under this head.
Short Duration Funds
Short-term debt funds come with a Macaulay duration of 1-3 years. They are low-risk funds but are higher in terms of risk than Liquid Funds and Ultra Short Duration Funds. The returns are also more likely to be affected by interest rate changes than the other two funds.
Medium Duration Funds
These funds invest in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between three and four years.
Medium to Long Duration Funds
Medium to Long Duration Funds invest in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is between four and seven years.
Long Duration Funds
Long Duration Funds invest in money market instruments and debt securities in a manner that the Macaulay duration of the scheme is more than seven years.
Corporate Bonds
Corporate bond funds put at least 80% of their investment in bonds of companies with the highest possible credit rating. The credit rating is given only to companies that are financially strong and have a higher probability of paying lenders on time.
Credit Risk Funds
These funds invest a minimum of 65% of their corpus in corporate bonds that have ratings below the highest quality corporate bonds. As such, these funds carry more credit risk but offer slightly better returns than Corporate Bond Funds.
Floater Funds
These funds invest at least 65% of their corpus in debt instruments that have variable interest rates. These funds have a low interest rate risk as the interest varies according to the market. As such, their returns are usually better than fixed-rate instruments. Floater funds can invest in corporate bonds as well as in loans made by banks to companies.
Fixed Maturity Plans (FMPs)
You can invest in FMPs only during the initial offer period. After that, you cannot make further investments in this scheme and it has a lock-in like fixed deposits.
Benefits of Debt Mutual Funds
Stable Income
Debt Funds have the potential to offer capital appreciation over a period of time. But you need to remember that even though debt funds come with a lower degree of risk than equity funds, the returns are not guaranteed and subject to market risks due to fluctuations in the underlying interest rates. There are also chances of default if the issuer does not repay.
High Liquidity
Debt mutual funds do not have any lock-in and you can, therefore, invest in debt funds if you have surplus funds lying around and need to put them somewhere for a short period of time.
Tax Efficient
Many people invest money for the primary reason of reducing their annual tax outgo. If that is the case with you also, then you can consider investing in debt mutual funds also. This is because debt funds are more tax-efficient than traditional investment options like fixed deposits. In case of debt funds, you pay tax only in the year you redeem and not before that.
Moreover, if you hold them for more than 3 years, then you need to pay long-term capital gains tax at 10% (without indexation benefits) or 20% (with indexation benefits) and not the usually higher short-term capital gains.
Note: We will cover indexation benefits when we discuss tax in the next module.
Flexibility
You have the option to invest a lump sum amount in debt funds and systematically transfer a small portion of the fund into equity at regular intervals. It helps in cost averaging and in reducing the volatility of your equity investments.
Diversification
Another reason to invest in debt funds is to diversify your investment portfolio. This can be a good way to reduce the overall portfolio risk in case you have a higher equity allocation in your portfolio. The debt component can help to cushion any downside risk to the returns.
Summary
Debt funds are better suited for investors who prefer moderate risk at best. The risk of investing in debt mutual funds is lower than in equity funds. As such, if you have a lower risk appetite and want to safeguard your wealth from unnecessary risky investments, then these funds can be a good choice for you. However, do keep in mind that some of these funds carry an entry load and even an exit load which can reduce your returns. And the best way to generate strong returns is to stay invested for the long-term.