What are debt funds and who can invest in them?
This article is about one of the low-risk mutual fund i.e. debt fund. However, these funds provide some limit amount of returns but the risk associated in these funds are very low as they utilized in government instruments. There is various type of debt funds and each has different benefits.
While equity mutual funds invest in public listed companies, debt funds invest in fixed-income securities of government and companies. These include corporate bonds, government securities, treasury bills, money market instruments and various other types of debt securities. Like a stock, investing in a company's equity is like buying a stake for the growth of that company. But when you buy debt fund, you give loan to the issuing entity. Government and private companies issue bills and bonds to get loans to run their various programs.
The interest you receive from these debt securities is determined in advance and its maturity period. Therefore they are called 'fix income' security because in this you know what you are going to get. Like equity funds, debt funds also raise good profits by investing in different securities. Debt funds offer good returns, but there is no guarantee of returns. Nevertheless, returns in debt funds can be estimated, which makes them safe for the conservative or small investor.
Various Securities in which debt funds invest
Debt funds invest in different securities with different credit ratings. The security's credit rating determines the risk of the entity issuing it.
A higher credit rating means that there is a better chance of interest payments and principal payments by that institution on maturity. Hence debt funds that invest in high-rated securities are less volatile than low-rated securities.
Apart from this, the other aspect is that the maturity period of the security in which the debt fund is being invested. Different debt funds invest in securities of different tenures. The shorter the time of maturity, the lower the probability of loss.
Types of Debt Mutual Funds
Debt mutual funds are of different types, just like equity mutual funds. The biggest difference between debt funds is the time of maturity.
Dynamic Bond Funds
These 'dynamic' funds, as the name itself suggests, mean that they keep changing their portfolio according to the changing interest rate. The timing of maturity of dynamic bond funds varies as they keep investing more or less over time depending on the interest rate.
Income funds also invest in various debt securities according to the interest rate, but most of them have a longer maturity period. For this reason, they are more stable than dynamic funds. Their average maturity period is about 5-6 years.
Short-term and ultra short-term debt funds
These are short-term debt funds with a duration of about 3 years. Short-term debt funds are better for the general investor as they are not affected much by changes in interest rates.
Liquid funds invest in debt instruments whose maturity period does not exceed 91 days. Therefore, there is less risk. They rarely see negative returns. These funds are a good option for savings bank accounts as they provide liquidity and large returns just like them. Many mutual fund companies also offer the facility to quickly withdraw liquid fund investments through special debt cards.
Gilt funds only invest in government securities. Government securities are high-rated securities and have low credit risk. This is because the government sometimes defaults in loans taken as debt instruments. Therefore, gilt funds are a good option for investors with fixed income who do not want to take the risk.
Fixed Maturity Plan
Fixed maturity plans (FMPs) are close and debt funds. They also invest in corporate bonds and government securities, but they have a time to hold capital. Every FMP has a fix time in which your capital is locked. This time can be a few months or years. One can invest in FMP in the initial offer period. FMPs are like a fixed deposit that offers great tax rebates, but there is no guarantee of returns.
How does the interest rate affect debt funds?
The interest rate that we often hear about in the news is the repo rate and reverse repo rate which is determined by the Reserve Bank of India (RBI). The RBI lends money to commercial banks at the repo rate. There are several reasons that are responsible for reducing or increasing the interest rate, the prevailing interest rate also determines the rate at which the entities issue bonds and debt securities. The price of fixed income securities is opposite to the interest rate. The bond price decreases when the interest rate rises. And the lower the price the higher. This is the reason why debt funds earn good profits when interest rates fall because their prices go up.
Why invest in debt funds?
This is a better option for a general and conservative investor. This is a good option for fix deposit. Debt funds pay interest only in the range of fixed deposits, but they provide tax exemption more than fixed deposits. The income from the fixed deposit gets added to your income and you have to pay tax according to that slab. Short-term benefits of debt funds also add to taxable income. But when the time period is more than 3 years, then there is more benefit in tax. 20% tax is levied after indexation on long-term gains. Debt funds are more liquid than fixed deposits. Where capital is locked in a fixed deposit, it can be withdrawn at any time in debt funds. It is also possible to withdraw some amount from the total amount in debt funds. Debt funds are better than fixed deposits for all these reasons. Nevertheless, it is important to keep in mind that unlike a fixed deposit, there is no guarantee of capital security or fix returns in debt funds.
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ABOUT THE AUTHOR
Pranav Sharma is a financial advisor who also loves to write articles in mutual funds and through this article, he has comprehended one of the low-risk type mutual fund called debt fund.