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Debt Funds

Investors have plenty of choices when it comes to mutual funds and it’s not difficult to find one that meets their investment goals and the risk they are prepared to accept. Among the different types of funds is the debt fund, which is meant for those who want steady returns but do not want the risk involved in equity investments. Debt mutual funds invest in fixed income instruments that include government securities, commercial paper, treasury bills, corporate bonds, money market instruments and other debt of varying maturities.

How debt funds work

As we have mentioned earlier, debt funds invest in fixed income instruments of varying maturities. Many of these, like government bonds, are not available to individuals but only to institutional investors. So individual investors are not able to realise gains from investing in them. And it’s a big market since the government is the largest borrower in the market!

Debt mutual funds do not always hold bonds till maturity and sell them before that for a margin. The gains that the mutual fund makes by this buying and selling is passed on the investor in the form of higher net asset values or NAVs. Fund managers also reinvest the interest received in debt funds, thus increasing the size of the corpus.

Debt funds also make money on interest rate movements. When interest rates fall, debt mutual funds make money. This may seem a little counterintuitive, so let’s explain. Let’s assume that a debt fund holds government bonds that carry an interest rate (or coupon rate) of 10 percent. Later the government decides to issue bonds at 9 percent. What this means is that the value, or yield, of the 10 percent government bonds goes up, and the debt fund is able to sell them at a profit and make gains for investors. The converse is also true, of course. When interest rates fall, so does the value of the debt fund’s holdings. So the NAVs will also fall.

Benefits of debt funds

  • Low risk: One of the biggest advantages of debt mutual funds is that the risks of investing in them are low. These funds offer the prospect of a steady income for investors who want to play it safe and avoid the volatility that is commonplace in the equity markets. Debt funds invest in government securities which carry very little risk. As far as corporate paper is concerned, good debt funds invest only in those that have a high credit rating.

  • High liquidity: Another advantage of debt mutual funds is that they’re much more liquid than most other fixed-income instruments. You don’t have to stay locked in for a long period of time, like a fixed deposit or a corporate bond. Amounts invested in debt mutual funds can be redeemed within a couple of days. In the case of liquid funds, it could even be quicker and take just a matter of hours.

  • Ideal for parking short-term funds: Debt funds are ideal for parking short-term funds. Suppose you receive a large amount and want to keep it somewhere for a short period of time until you decide what to do with it, you could put in a liquid fund or a short term fund. If you are accumulating money to, say, purchase a house, you can park your funds in debt mutual funds. You can earn interest on the amount while you wait, and since the risks are low, you can be fairly sure of getting a return on the money invested when you redeem the fund.

  • Diversification: Diversification of your portfolio is essential to reduce risk. While equity funds may offer better returns, they also involve a higher amount of risk. So it’s better to have some debt funds in your portfolio to balance the risk.

  • Meeting investment goals: Debt funds are suitable to meet certain kinds of investment goals. For instance, if you want a steady income after retirement, it’s better to invest a major part of your investment corpus in debt funds. Equity markets are volatile and you need to stay invested in a longer period of time to realise meaningful gains. Debt mutual funds don’t have this problem of volatility. Ideally, you should be investing at least 60 percent of your portfolio in debt funds after you retire.

  • Tax benefit: Debt mutual funds offer some tax benefits to investors. For example, if you invest in bank fixed deposits, the interest earned will be added to your taxable income and taxed every year. If you invest in debt mutual funds, on the other hand, you will pay taxes only when you redeem them. If you hold debt mutual funds for less than three years, the gains will be added to your income and taxed accordingly. If, however, you hold it for more than three years, you will have to pay 20 percent on the gains after indexation, or 10 percent without indexation. Dividends are free from tax, but there is a dividend distribution tax of 25 percent.

  • Investing small amounts: Another benefit of debt mutual funds is that you can invest small amounts each month through a Systematic Investment Plan or SIP. You can put in as little as Rs 500 each month. And by investing regularly each month, you have the potential to make much more gains rather than waiting to accumulate a certain sum and then invest.

Disadvantages of debt funds

  • Interest rate risk: The biggest disadvantage of a debt fund is the interest rate risk. When interest rates move up, the yields in the fund’s portfolio will fall, leading to a drop in NAVs. So you must be careful when you invest in a debt fund. If you feel that interest rates are going to rise, you might want to choose another investment avenue like fixed deposits.

  • Default: Another problem is the risk of default. If the debt fund is exposed to the debt of a company that is defaulting on its obligations, it will mean a loss for the fund. Investors have to bear the burden of this default in the form of lower NAVs. Of course, debt funds do take precautions by investing only in the paper that is highly rated by credit rating agencies. But credit rating agencies don’t always get it right. One way of getting around this problem is to invest in gilt funds, which invest in government securities.

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How to find the right debt fund

  • Risk appetite: You have to find a debt mutual fund that meets your risk appetite. Generally, funds that invest in government paper like bonds carry the most amount of risk. For instance, a gilt fund will invest only in government paper so there is very little risk of default.

  • Liquidity: Another factor to consider is liquidity, the length of time you want to invest your money in. For example, if you want to invest your money for a very short period of time, you would be better off with a liquid fund, which can be redeemed quickly, even within a day. If you are prepared to stay invested for a longer time, you can put your money in an income fund, which invests in fixed income instruments of a longer tenure.

  • Asset allocation: It’s important to look at the funds’ asset allocation – what proportion it invests in corporate paper and what percentage in government bonds. Generally, corporate bonds and debentures offer a higher rate of return than government securities, but also involve higher risk. If you are a cautious investor, you should go in for a debt mutual fund that has a major portion of assets under management in government bonds. However, you must remember that investment in government bonds carry interest rate risk and in a rising interest rate scenario, yields will drop along with NAVs.

  • Size of fund: It’s always better to invest in debt mutual funds that have a large corpus of assets under management. This is because investing in debt involves some transaction costs, and large funds are able to enjoy the benefit of economies of scale since they invest in bulk. They will also be able to negotiate a better interest rate from borrowers. This helps reduce the expense ratio. In smaller funds, there’s always the danger of overexposure to one or few borrowers, which won’t be the case with larger funds. Plus, a large fund will be able to handle redemption pressures better

  • Expense ratio: You have to look at expense ratios carefully. Since returns from a debt mutual fund are on the lower side, a high expense ratio could make a significant difference.

  • Credit rating: When you look at a debt mutual fund’s portfolio, you will also be able to see the rating of every corporate debt. Ensure that all the investments have a high credit rating. Of course, you must also remember that instruments with lower ratings will have to offer a higher rate of interest, so may earn more interest. But the risks too are commensurately higher.

  • Compare funds: Many websites rate debt mutual funds according to their performance. You can download the AngelBEE app for mutual fund investment to find the best fund.

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