Debt Mutual Funds

What are Debt Mutual Funds?

Debt funds are mutual funds that invest in fixed income securities like bonds and treasury bills. Gilt funds, short term plans, liquid funds, and fixed maturity plans (FMPs) are some of the investment options in debt funds. Apart from these categories, debt funds include various other funds investing in short term, medium term and long-term bonds.

Debt funds do not invest in equity. They only invest in debt instruments issued by the government, banks, and corporate entities; thereby making them much less risky compared to equity mutual funds, alleviating concerns of risk-averse investors. Debt Funds can generate relatively stable returns (7-8% annualized).

Benefits of Debt Mutual Funds

Asset Allocation

Even the most risk seeking investors should have debt as a component of their portfolios. The variety of Debt Funds available provide options for investors with all kinds of time horizons and offer more attractive returns than bank deposits.

Invest in Equity Via STPs

If you wish to invest a large sum in an equity fund, but want to stagger the investments over a period, put your money in a liquid fund or ultra-short term debt fund and enroll for a systematic transfer plan (STP) whereby you invest a fixed sum from your debt fund to an equity fund each month/week. This helps you enhance your returns by utilizing rupee cost averaging just like SIPs.

Much better than Bank FDs in Most Cases

Unlike FDs, Debt Funds do not offer assured returns, nor do they guarantee the principal amount as they are subject to market risks (interest risk and credit risk). However, in most cases the pre-tax returns compares attractively to the bank deposits and post-tax returns are even better because they benefit greatly from taxation in the long run (and indexation post 3 years).

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How are earnings From Debt Funds Taxed?

If held for less than 3 years, capital gains from debt funds would be added to investor’s income and taxed at his marginal rate of tax. If held for more than three years, investors will have to pay Long Term Capital Gains (LTCG) tax at 20% with indexation.

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Choosing a Debt fund

You should invest in a debt fund depending on the period for which you want to make the investment. Or in other words, match your investment horizon with that of the debt fund. For example, if you have an investment horizon of three months, liquid funds would be the best bet for you.

Look at the modified duration, which is a measure of sensitivity of your debt fund to interest rate volatility. Fund houses disclose modified duration of in monthly fact sheets.

Keep an eye on the exit load of the debt fund. Some funds levy a penalty for exiting before the minimum period.

Types of Debt Funds

1

Overnight Funds

holding portfolio with maturity up to 1 day

2

Liquid Funds

holding portfolio with maturity of up to 91 days

3

Ultra-Short Duration

holding portfolio with maturity of 3-6 months

4

Short Duration

holding portfolio with maturity of 1-3 years

5

Money Market

holding portfolio of money market instruments with maturity of up to 1 year

6

Medium Duration

holding portfolio with maturity up of 3-4 years

7

Medium to Long Duration

holding portfolio with maturity of 4-7 years

8

Dynamic Bond

can invest across maturity duration

9

Long Duration

holding portfolio with maturity of more than 7 years

Corporate Bond

at least 80% in corporate bonds (AA+ & above)

Banking and PSU

at least 80% in instruments issued by banks, PSU undertakings, municipal corporations, etc.

Gilt

at least 80% in instruments issued by government across periods

Gilt with 10-year Constant Duration

at least 80% in instruments issued by government across periods such that the average maturity is 10 years