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What are Debt Funds?

mahindra-finance-author

by Mahindra Finance

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June 30, 2023

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4 mins read

What are Debt Funds?

Holding on to a day job and also managing one’s investments can be challenging for the best of us. Deciding on where, when and how much to invest can mean hours of research that many people cannot afford.

To invest in mutual funds is to put money into an asset class of one’s choice--equity, debt, money markets or a pre-specified mix of these, with the assurance that professionals will be managing these funds and deciding ultimate allocations of the pooled assets in line with the fund’s stated objectives.

Investors can base their choice of mutual funds on various criteria, including their end financial goal and overall risk appetite. Among the numerous mutual funds available to investors, fixed-income or debt mutual funds are ideal for conservative investors with minimal risk appetite.

What are debt funds and their benefits?

In debt mutual funds, investments are made across short and long-term government bonds, corporate bonds and money market instruments such as treasury bills or certificates of deposit, though this list is not exhaustive.

As the name suggests, debt instruments are essentially financial products of varying durations and risk profile, which enable the purchase and sale of debt or loans in return for an interest income.

Simply put, with debt mutual funds, investments are made in financial instruments that come with a pre-specified date of maturity and interest rate, allowing investors to earn interest income on maturity. Unlike equities, the returns on these debt instruments are not affected by any volatility in the financial markets. This is largely why debt funds are recommended to investors whose main goal is the preservation of wealth and a steady income.

Debt funds can vary in duration from as little as a few days or months to at least a couple of years, based on the instruments that make up the investment portfolio.

Fixed-income or debt mutual funds rank higher in safety and guarantee of returns (to an extent), compared to equity mutual funds. However, debt funds also differ in risk parameters based on which instruments comprise the portfolio; this is because debt instruments or products also come with a credit rating based on the likelihood of a default on the principal and interest payment by whoever has issued the instrument or taken the loan. The higher the rating, the lower is the risk of default.

Risks Involved

This also means that the highest-rated instruments may provide lower returns. This is because of the risk-reward principle. Lower the risk, lower the returns and vice versa

Talking about risk, debt funds may be less risky than equities, however, investors still take some form of risk when investing in debt instruments:

  • One risk investors take when buying debt is that the issuer may be unable to repay the principal or interest.
  • There is also the risk that the fund house one invests with may not have enough liquidity to be able to meet redemption requests, i.e. pay what is owed to investors who wish to withdraw units from the scheme and get back their investment, which is valued at the net asset value on the day of the withdrawal.
  • Another risk is that fluctuation in interest rates may also affect the value of one’s debt holdings.
  • Another aspect an investor should take note of when investing in mutual funds is the expense ratio, which is lower for debt funds compared to equity funds. The expense ratio is a percentage of the mutual fund scheme’s total assets that is set aside as fees for the management of the fund.

Among other things, the expense ratio sets apart the variety of debt funds available to investors through various fund houses.

One important factor to note when investing in debt funds is that capital gains earned on units of a scheme held by investors for up to three years is referred to as short-term capital gains and is part of your taxable income and taxed as per the investor’s income slab.

Meanwhile, capital gains earned on units held for over three years is referred to as long-term capital gains and taxed at 20% with indexation benefits.

Conclusion

Debt funds differ in duration from overnight to several years and the best debt fund is one that matches with the investor’s level of comfort for risk. While debt mutual funds offer the comfort that one’s money is managed by a professional, one must still take the time to go through the fine print and choose a fund with a competent money manager at the helm.

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