What are Debt Funds? Meaning & Mutual Funds Benefits

India’s young investors have grown up seeing their parents invest in Fixed Deposits and Post Office Schemes. Interest rates were high during that period making FDs and PO schemes attractive, and equity markets were considered for investment only by a few investors. Even today, the debt market is a place many investors prefer to invest their money in because debt instruments are not volatile and risky as equity instruments. Debt investments offer them a steady income with less risk and hence they are okay to accept a slightly lower return than equity investments. Today, we discuss debt funds in detail and the benefits of investing in them.

Debt funds are a type of mutual fund that primarily invests in fixed-income securities like Government Bonds, Treasury Bills, Corporate Bonds, and other money market instruments. The primary aim of such funds is to provide investors stabilised returns that are not affected by normal market fluctuations. As a result, they are also called Fixed Income Funds or Bond Funds.

A debt fund is a mutual fund that invests in debt instruments. This is also a key difference between debt funds and equity funds as they invest in different assets. A debt fund can generate income by earning interest that is paid by the debt securities that the fund invests in. Interest income earned is either reinvested into the fund to buy more securities which leads to the appreciation of the fund NAV or, it is distributed to the investors as dividends depending on the type of scheme.Another source of income for these funds is the income earned by the way of capital appreciation. A debt fund regularly purchases and sells debt securities of various durations. The difference earned from the cost price and the selling price is the profit of the fund which is added to the fund’s portfolio hence appreciating the fund’s NAV.A debt fund invests in debt instruments depending on the objective of the fund. The objectives of the fund decide the type of debt instruments that the fund invests in. There are various criteria to decide the type of debt instruments for investment like credit rating of the bond, time to maturity, expected interest, the issuer of the bond, etc. For example, a Gilt fund can only invest in government securities. A Credit risk fund invests majorly in securities rated AA and below. Hence, it is important that the investor invests in a fund that matches their investment objective.Before we understand the types of debt funds, it is necessary that we learn some important keywords used in debt funds so that we can understand them in a better way.

1. Average Credit Rating

Governments, PSUs, and Corporates have a credit rating based on their creditworthiness and the future outlook of their business. The higher the rating, the safer they are, and vice versa. As safety increases, interest offered by them decreases, and so on. An investor can choose to invest in a fund by looking at the average credit rating of the securities in the portfolio based on their risk appetite.

2. Average Maturity

Unlike equity instruments that are perpetual in nature and without a maturity date, a majority of debt instruments have a maturity date. It is advisable for an investor to invest in debt instruments that have a maturity period equal to their investment horizon. For example, if an investor wants to invest for 5 years, then they should invest in bonds that expire within 5 years from the date of their investment. This way they can tackle risks like interest rate risk, reinvestment risk, and volatility risk. Average Maturity shows you the weighted average maturity of all the debt securities held by the fund. Helpful for investors who want to prefer a scheme that matches their investment horizon.

3. Yield to Maturity

The Yield to Maturity (YTM) ratio tells an investor about the returns they can expect from the bond if the bond is held till its maturity. It factors in the expected cash flow from the bond, its market price, its face value, and the time till maturity to arrive at the annualised return one can earn if they hold the bond till its maturity.Because it is calculated using the Time Value of Money, YTM is a more realistic approach to calculating expected returns. A fund’s YTM shows the return the fund is expected to generate if all the bonds in the fund’s portfolio are held till their maturity. YTM can change if the assets in the portfolio change.

4. Modified Duration

Bond prices are sensitive to interest rate fluctuations. Both are inversely related and any change in interest rate will bring an opposite change to its price. Modified duration helps you determine the sensitivity of the price of the bond with respect to interest rate fluctuations. The higher the ratio, the higher the sensitivity. For example, if the modified duration of a bond or a debt fund is 3 years, this means that if the interest rates change by 1%, the price of the bond will change by 3%. Investors can use this ratio to adjust the interest rate risk in their portfolios.

1. Overnight Funds

Such funds deploy funds in securities with a maturity of 1 day. This means that the securities in this portfolio get updated every day. Because of this feature, it is considered a fund with zero to negligible risk. Investors with a very short-term horizon can prefer overnight funds.

2. Liquid Funds

A type of debt fund that deploys a majority of its portfolio in securities that mature within 91 days. As a result, they are best suited for funds that are to be parked for liquidity purposes. Liquid Funds are considered a competitor of savings bank accounts as it offers more return than a savings account.

3. Ultra Short Duration Fund

Such funds invest their portfolio in securities with maturity anywhere between three to six months. These funds have slightly higher average maturity than liquid funds and hence also offer a little more returns than liquid funds.

4. Low Duration Fund

A debt fund that invests in debt instruments with maturity between six to twelve months.

5. Money Market Fund

A debt fund that invests in money market instruments with a maturity of less than 1 year. Such a fund is an ideal avenue for investors to park their emergency funds.

6. Short Duration Fund

Such funds are ideal for investors with a short-term investment horizon as the fund invests in debt securities with maturity between one to three years

7. Medium Duration Fund

A type of debt fund that invests in debt securities with an average maturity of the portfolio between three and four years.

8. Medium to Long Duration Fund

This type of debt fund invests in debt securities in such a way that the average maturity of the fund comes anywhere between four to seven years.

9. Long Duration Fund

Such funds invest in debt instruments in such a way that the average maturity of the portfolio is over seven years. Ideal investment avenue for investors who want to stay invested for a longer duration.

10. Dynamic Bond Fund

Interest rate cycles keep on changing over the years and it can be difficult for an investor to time the interest cycles. Hence, dynamic bond funds help investors who do not want to time the cycle. Such funds invest in securities based on the outlook of the interest rate cycle. If the fund manager feels that the interest rates are going to rise, the fund invests in short-term securities, and if the fund manager is of the opinion that the interest rates are going to decrease, the fund invests in long-term securities. The fund keeps on adapting to the interest rate cycle and dynamically adjusts its portfolio.

11. Corporate Bond Fund

As the name already suggests, the fund invests a majority of its portfolio in corporate bonds with the highest ratings. It aims to generate stable returns for investors with moderately lower risk.

12. Gilt Fund

This type of fund is ideal for investors who want to invest in G-Secs. Such funds invest a majority of its portfolio in government securities diversified into various maturities. As securities in the portfolio are G-Secs, there is no default or credit risk and only interest rate risk.

13. Banking and PSU Fund

Such funds invest a major proportion of its total assets in debt securities of Banking and Public Sector Undertakings (PSUs).

14. Credit Risk Fund

This type of fund aims to generate a little higher returns by investing in corporate bonds with ratings equal to or lower than AA. They are able to earn more returns as there is a credit risk in such bonds and hence investors who are okay with a little higher risk prefer such funds.

15. Floater Fund

This type of debt fund invests majorly in debt instruments that offer a floating rate of interest. This way, the fund tries to neglect the interest rate risk as such securities are linked to a benchmark rate, for example, MIBOR. The variable rate keeps on changing as per the movement in interest rate. This way investors earn returns according to the rate close to the current interest rates.

16. Fixed Maturity Plans (FMPs)

This type of debt fund is a close-ended fund whereby there is a maturity date for the fund just like fixed-income securities. Such funds invest in securities that have a maturity date close to the maturity date of the fund. As the funds are locked-in once the subscription is closed, the fund manager can invest in securities without the risk of premature redemptions and unwarranted outflows that can risk the yields of the portfolio. Such plans are also listed on the stock exchange so investors who want to exit can exit in the secondary market.

1. Insensitive to Market Volatility

One of the biggest reasons why investors prefer to invest in debt instruments is their insensitivity towards volatility. Whenever an investor invests in equity or equity-based instruments, they are exposed to market volatility and fluctuations. And any change in the macros or internal factors can bring a rapid dip in their portfolios. Debt funds are usually safe from such volatility offering investors stability in their portfolios.

2. Debt Fund for every need

Debt funds are available in several types across maturity periods, different issuers, different credit risks, and with dynamic interest rates. This helps an investor invest in a debt fund for any kind of need.Want to park your emergency fund? Here is Overnight or Money Market Fund. Want to park in the highest rated corporations? Invest in a corporate bond fund. Want to invest without the fear of interest rate risks? You got a dynamic bond fund and floater fund.With a variety of debt funds, an investor can be rest assured to find a fund for his/her needs and invest in them to achieve their goals with lower risks.

3. Provides you the much-needed diversification

“Don’t put all your eggs into one basket.” When it comes to investment, this saying is an age-old golden rule. Investing in one asset is risky. The performance of the single asset can bring high fluctuations. On the other hand, if you diversify your asset allocation, the curve gets smooth, and the  poor performance of a single asset does not affect the overall portfolio much. Debt funds being slightly less risky and more stable than equity funds provides the needed stability and gives you the benefit of diversification.

4. Professional Management

When it comes to investing on your own, you need to allocate too much of your time to analyse, research and find the best suited investment for your needs. Debt Funds are managed professionally with the oversight of a fund manager. Such fund managers are capable to analyse, research and find the best suited opportunities according to the objectives of the fund and earn the profits on your behalf. You just need to look for the right fund according to your needs and the rest will be taken care of.

5. Can be a good partner for your Equity Funds

If you are fearful of investing in equity funds all at once, you can take help of debt funds and build your wealth creation innings slowly. You can invest the surplus amount in a debt fund and systematically transfer amounts at regular intervals into equity funds using STP. This way you enter into the equity market slowly across cycles without worrying about timing the market right.Another use case of using debt funds as a partner is to use it as a shield to protect your goals from volatility. What we mean is once you start nearing the due date of your investment goal you should start shifting funds from equity funds or other volatile assets into stable investments like debt funds. It is possible that markets become volatile just before the time you are approaching your redemption date and as a result you have a shortfall of funds. Debt funds are a workable solution for such situations.Whenever you are near to your goal, it is always a good idea to start shifting investments into more stable options like debt funds so that you don’t miss your goals and ride towards them smoothly.

In the Income Tax Act, Debt Funds are defined as funds that invest more than 65% of their total assets in debt instruments and are not exposed to equities by more than 35%. Earlier debt funds used to be taxed into STCG and LTCG.
But, starting 1st April 2023, all the gains made from debt funds will be considered as Short-Term Capital Gains and will be added to the total income of the taxpayer. This means that the earlier benefit of indexation will no longer be available. Final Word Debt Funds are a good option for the investors who want to stay away from market fluctuations and those who are risk averse. They offer the investors a chance to earn stable returns by taking less risk. However, it is important to note that as the risk gets lower, the expected returns from the asset class also gets lower.As debt funds are a vast topic and there are a variety of funds to be chosen from, it is necessary that an investor decides their investment objective and their risk appetite before investing into any kind of funds. Also, it is necessary that investors choose the right scheme for their needs after doing necessary research about various debt funds.