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Debt mutual funds came in the news in the beginning of the 2023-24 financial year following a key amendment in the Finance Bill 2023. As per this amendment, with effect from 1st April 1, profits made on debt mutual fund investments will be taxed as short-term capital gains if these funds invest no more than 35% in equities.Basically, what this means is that debt mutual funds will now be taxed as per the income tax rates applicable for an individual’s income.Analysts see the move aimed at high net-worth individuals (HNIs), who would use debt funds as tax-saving instruments.So what are debt funds? In this article, we will explore that and also see how you can get the best out of debt funds following the new rules. But do keep in mind, talking to an authorised financial advisor always makes sense.
What is a debt fund?
A debt fund is a mutual fund that pools ed from various investors and collectively invested in in fixed income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation.Debt funds also have a low-cost structure and offer relatively steady returns and high liquidity; this is why they are commonly known as income funds. Plus, as stated earlier, they are reasonable safe and are ideal for individuals with a low-risk tolerance.The interest rate and maturity date of debt mutual funds are predetermined, providing investors with knowledge of the maturity amount at the time of investment.
Debt fund features
Now let us look at the broad debt fund features, as listed below:
The risk involved in debt funds is low.
We mentioned this earlier: debt funds are low-risk investments as they are relatively unaffected by stock market volatility, and fluctuations in the interest rate are minimal and not as drastic as in stock markets. Additionally, debt funds invest in fixed-income securities, which allows investors to know both the maturity date and interest rate of their investments.
Duration of the debt funds
All debt funds have a specific duration, during which period the funds invested are blocked. This period varies – from a day for overnight funds to 10 years for gilt funds. During this period, the invested amounts accumulate interest. The principal and the accumulated interest are repaid to the investor at time of maturity.
Capital appreciation is low
If substantial appreciation in investment is the aim, debt funds may not be the best bet; capital appreciation is low here. But what investors can look forward to are a fixed source of income and returns in the form of interest payments. When investing in debt, the issuer company repays the borrowed loan amount, while the interest portion is generated through reinvestment of the maturity amount from the gains in revenue. The main aim of this type of investment is to provide a safe and stable return.
Credit quality is rated
Investors are known to check credit ratings assigned to various debt instruments / fixed-income securities such as commercial papers, debentures, bonds, or corporate deposits when investing in debt funds, as these funds invest in these debt instruments . The ratings are assigned by rating agencies such as ICRA, FITCH, CRISIL etc.
How do debt mutual funds work?
Being mutual funds, debt fund investments are managed by fund managers; it is they who are responsible for ensuring the fund’s quality through their investment strategy.They may invest in debt securities with a high credit rating as they are less volatile, but may also take a calculated risk to maximize returns by investing a portion of the investment amounts in securities that are not rated as high but offer higher returns.They may also invest in short-term securities when interest rates are expected to rise in the near-term and long-term securities when rates are expected to fall in the long run. This is done to hedge the portfolio against interest risk and to ensure a balanced portfolio with good returns.Also read: 5 Key Parameters For Debt Fund Investment
Types of Debt Funds
Debt funds can be categorised based on their duration and investment avenues, as listed below:Some of the debt fund investmentsare:
FAQS - FREQUENTLY ASKED QUESTIONS
What is the difference between debt funds and fixed deposits ?
The difference between debt funds and fixed deposits are as follows:
The returns and the risk involved are higher in debt funds than in fixed deposits.
Investments in debt funds can be withdrawn at any time, whereas fixed deposit withdrawal will fetch a penalty if withdrawn before maturity.
Fixed deposits and debt funds are taxed differently. TDS is not deducted in debt funds, whereas it is deducted in fixed deposits.
A lump sum is invested in a fixed deposit, whereas an investor can invest in a debt fund using SIP or lump sum.
Read more about debt funds vs fixed deposits here.
What is the difference between debt funds and equity funds ?
The difference between debt funds and equity funds is as follows:
Debt funds invest in debt securities like corporate bonds, government bonds, and treasury bills. On the other hand, equity funds invest in the equity /shares of companies that are listed on the stock exchange.
Debt funds have a lower risk and lower returns than equity funds.
The returns and interest rates are already known to the investor in debt funds. Equity funds rely entirely on the stock markets for the returns, which are not pre-determined.
Read more about debt vs equity funds here.
What sort of risks are involved in debt funds ?
There are three types of risks involved with debt funds. These are:
Interest rate risk - The bond price and the interest rate are negatively co-related; if the interest rate increases, the bond price decreases and vice versa. Plus, the longer the duration of the debt funds, the bigger is the exposure to fluctuations in interest rates, which increases the risk.
Credit risk - In debt funds, an investor lends money to the company. Chances of repayment depend a lot on the credibility of the borrower. The risk is in the borrower's repayment capability, which is known as credit risk.
Liquidity risk - If the debt securities held by an investor are not in demand and there aren’t any buyers, then if the idea is to sell it before the maturity of the units, this may have to be done at a loss.
Every debt mutual fund needs to have a Potential Risk Class Matrix, also referred to as the PRC matrix. SEBI has mandated this. Read more about the PRC Matrix here.
How much return can debt funds give ?
Debt funds offer better returns than fixed deposits but lower returns than equity investments. In 2022, some of the best debt funds yielded 10% to 25% returns. At the same time, long duration debt funds and gilt funds gave only around 3% returns per annum. Therefore, investors must choose their investments wisely, considering all factors like duration and risk involved.
What things need to be considered before investing in debt funds ?
Before investing in debt funds, an investor needs to know a few things, which are:
The risk to be taken.
The duration of investment; an ideal tenure for investing in debt funds would be three months to a year.
The goals to be achieved.
The expense ratio; this is the fee levied by the mutual fund companies, which can end up increasing the cost of the debt fund investment.
What are accrual debt funds ?
Accrual debt funds are investments with a short-term to medium-term maturity period. These funds invest in debt instruments carrying a lower credit rating. Instruments with a lower credit rate offer higher returns because they carry credit risk (risk of default). Typically, these investments are held till maturity.
What are infrastructure debt funds ?
Infrastructure debt funds invest only in projects related to infrastructure. Institutional investors (offshore and domestic) are allowed to invest in them. They are sponsored by NBFCs and commercial banks in India, which issues units and bonds for infrastructure projects.
What is credit-risk debt funds ?
Credit-risk debt funds are debt mutual funds that invest in low-rated securities to earn high returns. Debt fund managers take a calculated risk by investing in such securities just to maximize returns .
What are the types of debt funds ?
Debt securities include corporate bonds, government securities, and money market instruments. The debt funds are categorized based on the maturity period of the investment and the kind of security. Some of the most prominent types of debt securities available in the market are liquid funds, ultra-short funds, money market funds, corporate bond funds, short-duration funds, overnight funds, low-duration funds, medium-duration funds, corporate bond funds, gilt funds, dynamic funds.
The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.
