What are Debt Mutual Funds? regular income with low risk
Debt market is a huge market in which people invest their earnings to earn profit. In Debt Fund, you get 7 to 8% return on very nominal risk and that too with high liquidity. You can redeem the debt fund anytime without any penalty. Debt funds can be a good option for such investors who want to earn profit with low risk. However, debt funds give lower returns than equity funds.
In this article we will talk about what are debt mutual funds, what are the types of debt mutual funds and complete information about debt funds.
What is Debt Mutual Fund?
Before talking about debt mutual funds, let us know what are debt instruments. If understood in very simple language, then money is lent to a person in debt fund. In return, that person issues a debt instrument to the lender. The borrower repays the money after a certain period of time with a fixed rate of interest. When the money is returned, the debt instrument is returned by the lender to the borrower.
They are called debt funds because the issuer of the instrument borrows from the lender against the debenture.Debt mutual funds are funds that invest their money in government securities, commercial papers, certificates of deposit (CDs), treasury bills and other money market instruments.
All the securities in which debt funds invest carry a fixed rate of interest. Because of this, they are also called fixed income securities. Also, these instruments have pre-determined maturity dates. Due to the fixed interest rate, the returns of debt funds are unaffected by the market uncertainties.
How do Debt Funds works
Debt instruments are mainly issued by the government and companies. Investing in Direct Debt Funds can be a daunting task for a common investor. Also, a huge amount is also required to invest in Direct Debt Funds.
Hence the concept of debt mutual fund was introduced to invest in debt funds. Debt mutual funds are an indirect way to invest in debt funds.
As an investor, the money you give to the fund house is used by the fund house to buy debt fund instruments. In equity mutual funds, AMCs buy shares with investors’ money, while in debt funds, AMCs lend investors’ money to financial institutions, governments and companies.
The choice of debt instruments for debt mutual funds is done by the fund manager. The fund manager can invest in high quality or law quality instruments as per the goals of the fund.The returns of debt mutual funds are decided on the basis of interest earned on these debt instruments.
Benefits of Debt Mutual Fund
(i) Portfolio Diversification – If you add debt mutual funds to your portfolio, it provides diversification to your portfolio. It protects your portfolio from volatility in the equity market.
(ii) No Lock-in- Period – There is no lock-in-period in debt funds like Fixed Deposit or ELSS Fund J. You can withdraw your money whenever you want without any penalty.
(iii) As an emergency fund – Debt fund mutual funds can be a good option for an emergency fund. Debt funds can be a good alternative to FD if you want to keep some money as an emergency fund with high liquidity.
(iv) Law Risk – Debt funds can give good returns to the investors at nominal risk. Along with other investment options, it can manage your risk.
Drawbacks of Debt Mutual Fund
(i) Low Returns – Debt funds with their limitations do not generate good returns for the investors. Especially when the interest rate has fallen in the market. When the economy is not on track, they can give you less returns than FDs.
(ii) Additional cost – Mutual fund houses (AMCs) charge certain expense ratios if you invest in debt funds through mutual funds. Due to this, the returns of the Debt Fund are slightly reduced.
(iii) Not Goal Based – Through Debt Fund you can park your extra money or fulfill your short term goals. But this option is not considered good for long term goals.
(iv) Credit Risk – Sometimes the money lent is not able to return its principal and interest. Its direct loss is to the investors. The chances of this happening increase when fund houses invest in law quality bonds.
(v) Liquidity Risk – At times due to high redemption requests coming in, the fund manager may face the problem of liquidity.
Types of Debt Mutual Funds
There are many types of debt funds available in the market, whose details are given below –
(i) Liquid Funds – These types of funds invest their money in such instruments whose maturity is maximum 91 days. Liquid funds provide high liquidity to the investors. Their investments are mainly in treasury bills, commercial papers and certificates of deposit.
Liquid funds are considered a good option for savings account and off-short term investment. You can read more about what are liquid funds here.
(ii) Money Market Funds – These invest their investments in money market instruments with a maximum maturity of 1 year.
(iv) Ultra Short Term Funds – These are invested in short duration instruments. They invest in instruments like money market. Their maturity period is 3 to 6 months. These are considered good for investors who want to manage their cash for the short-term.
(v) Short Duration Funds – These invest in government and corporate bonds with a maturity period of 1 to 3 years.
(vi) Gilt Funds – Gilt funds invest only in government securities which have high credit rating and low credit risk. Since investing only in government securities, the amount of risk in these funds is negligible.
For investors who do not like to take risk at all, gilt funds can be a good choice.
(vii) Credit opportunities Funds – are comparatively new debt funds. These types of funds try to earn high returns by taking high risk. So they invest their money in law rated debt funds. The degree of risk in such debt funds is slightly higher.
(viii) Fixed Maturity Plans – These are close ended debt funds. These funds invest in fixed income securities such as government bonds and corporate bonds. The money in this type of fund is locked for a fixed period of time.However, in these types of funds, you can invest in the initial phase itself, no new investments can be made in them later.
(ix) Banking and PSU Funds – These funds mainly invest in Banking, PSUs, Financial Institutions and Municipal Bonds. Their investment in this type of instrument is about 80%.
How much risk is there in Debt Mutual Fund?
The degree of risk depends on the type of debt fund you are investing in. Debt funds carry much less risk as compared to equity funds. Debt funds that invest in high rated bonds and government bonds carry very little risk. Because they pay back their loans.
But debt funds that invest in law quality bonds that offer higher rates of interest are also more prone to default. Therefore, the risk is also high in it.Overall, debt funds do carry risk, but due to the fixed interest rate, its quantum is very less.
How much return do debt funds give?
Debt funds offer lower returns as compared to equity funds. Also, there is no guarantee of fixed returns. The NAV (Net asset value) varies depending on the interest rate. If interest rates increase, the NAV also increases and if the interest rate falls, the NAV also decreases.
Generally debt funds offer returns of 7 to 8% but it completely depends on the interest rates of the bonds. If the interest rates on bonds are low in the market, then debt funds will also get low returns.
Debt Mutual Fund Expense Ratios
Expense Ratio is a very important parameter while choosing a Debt Mutual Fund. Expense ratio is the fee charged by the fund house as fund management fee. SEBI has put a maximum limit of 2.25% for the expense ratio on debt funds.
The returns of such funds are not high anyway, so higher expense ratios can reduce your earnings. Therefore, while choosing a debt mutual fund, special attention should be paid to the expense ratio.
Debt Mutual Fund Taxation
Capital gains tax is to be paid on the capital gains made on this type of fund. If you sell the debt fund before 3 years or before 3 years, then the profit earned is added to your income and taxable as per your tax slab.
Long term capital gains tax is payable if the debt fund is sold after 3 years. LTCG is taxable at the rate of 20% after the benefit of indexation
You have to pay tax only when you have redeemed your mutual funds.
Who should invest in Debt Funds
These funds are considered best for those investors who are willing to take moderate risk from the law. Debt funds carry less risk than investing in equity funds.
Such investors who want to invest for short to mid term by adopting a defensive approach can take exposure of debt funds in their portfolio. Also, even if you have some surplus funds, you can invest in debt funds.
Diversifying your portfolio is another reason to invest in debt funds. If you have high equity exposure in your portfolio, you can reduce your exposure to some extent by investing in debt funds.Debt funds provide some protection against the downside risk of your portfolio.
How to invest in Debt Fund
There are mainly two types of investments in debt funds.
1] Lump Sum
If you have a huge corpus and want to invest it all at once, you can do lump sum. In this, it is not so important to see the market conditions while doing the Lam Sum.
On the other hand if you want to invest regularly and disciplined in debt funds then you can start investing through SIP.
Conclusin (What Is Debt Mutual Funds)
In summary, Debt Mutual Funds are those funds that invest their money in instruments like Government Bonds, Corporate Bonds, Treasury Bills etc. These instruments carry a fixed rate of interest along with a fixed maturity period.
Thus, money in debt funds is lent to different individuals rather than investing in the equity market, in return for which they pay a fixed rate of interest.
Friends, today you understood what are Debt Mutual Funds, how do Debt Mutual Funds work. If you liked this information, then definitely share it on social media networks.