The mutual fund environment is filled with different assets – which broadens your horizon for options. Investing in mutual funds has increased ever since the break-out of the pandemic in 2020. The easy access to the internet, the bigger exposure to investing from home, and so much more bought a surge of new investors to mutual funds. So, here we can discuss debt funds – shall we?
What is the Meaning of Debt Funds?
Buying a debt instrument could be seen as a loan to the entity that issued the asset. A debt fund will invest in fixed-income securities like corporate bonds, treasury bills, government securities, commercial paper, and several other money market instruments in order to generate interest.
The basic reason to invest in debt funds is to get a consistent interest income with capital growth. Debt asset issuers pre-determine the interest rate and maturity period you would receive. As a result – they’re also referred to as ‘fixed-income’ securities. So, here we can look at the types and best debt mutual funds in the market today.
There are different types of debt funds – and they vary from one another.
The Different Types of Debt Funds
- Liquid Funds: Liquid debt funds are easily convertible into cash and have a 91-day maturity date. They are risk-free due to their short maturity time, but they also deliver the most consistent returns. Treasury Bills, CDs, and Certificates of Deposit are used to make the investment.
- Dynamic Bond Funds: Dynamic Bond Funds switch back and forth between long-term and short-term funds with varying maturity characteristics. The funds invest in a variety of debt and money market products while keeping interest rates in mind. Dynamic bond funds are a great option for those with a medium to high-risk appetite.
- Income Funds: Income debt funds invest in debt instruments with a variety of maturities, but the majority are for the long term. Income funds have a 5- to 6-year average maturity period. Income funds would invest in some government securities and corporate bonds while keeping interest rates in mind. As a result, income debt funds may be better suited for those with a little higher risk appetite and longer investment horizons.
- Short-Term Funds: Short-term debt funds, as the name implies, have a shorter maturity period, ranging from one to three years. They compile the money in government bonds, debt, and money market products. Short-term debt funds may be best suited for investors who have a low to moderate appetite for risk. When interest rates are high – the funds perform well. Short-term funds can be an excellent investment option if you have money to invest for 9 to 12 months and a low-to-moderate risk appetite.
- Ultra-Short Term Funds: These funds also have short maturity terms, typically under a year. While the majority of the money is put into ultra-short-term debt instruments, a tiny fraction is put into long-term assets as well. Ultra short-term funds have a low-risk profile and may be the ideal investment option for those looking to invest for a period of one to twelve months.
- Fixed Maturity Funds: Fixed Maturity Plans, or FMPs, have a set locked-in time, as the name implies. It would last anywhere from a few months to several years. The FMPs are unaffected by fluctuating interest rates because of the lock-in period. As a result, the fund’s NAV, or Net Asset Value, remains unchanged. Fixed Maturity Plans are considered the greatest alternative to fixed deposits because they are closed-ended and tax-efficient.
- Credit Opportunities Funds: Credit opportunity funds invest in a variety of assets. Short-term to long-term investments are made with the purpose of maximizing profits. These debt funds are ideal for investors who want bigger returns but are willing to take a chance.
- Gilt Funds: Gilt debt funds exclusively invest in government-issued securities from the federal and state governments. The maturity time might be anywhere from medium to long. There is no credit risk with gilt funds because they are government-issued debt funds. Your money is protected. Because government assets are susceptible to interest rate changes, this does not mean that gilt funds are risk-free. Gilt funds are a good choice for those who want to invest for the long term and prefer government-backed investments.
There are some other factors that you will have to consider before you start investing in debt funds.
Factors to Consider Before you Invest
Here are some attributes you should not overlook with debt funds:
- Debt funds are riskier than a bank FD – since they are subject to credit risks and interest rate risks. The fund manager could invest in securities with a low credit rating and a higher chance of default. Bond prices could fall because of an increase in interest rates in interest rate risk.
- There is the expense ratio – it is a cost charged by debt fund managers for managing your money. The expense ratio must not exceed 2.25% of assets, according to SEBI regulations. Given the lower returns provided by debt funds over equity funds, a long-term holding period would aid in recouping the money lost due to the expense ratio.
- Even though debt funds are safe havens for fixed-income investors, they do not guarantee returns. With a rise in overall interest rates in the economy, the Net Asset Value (NAV) of a debt fund tends to fall. As a result, they’re well-suited to a low-interest-rate environment.
- If you have a three-month to the one-year investing horizon, liquid funds may be a good choice. Short-term bond funds, on the other hand, can have tenures of two to three years. Dynamic bond funds would be good for an intermediate horizon of three to five years.
- Debt fund capital gains are taxed. The tax rate is determined by the holding period or how long you keep your money in a debt fund. Short-Term Capital Gains are capital gains made over a period of fewer than three years (STCG). Long-Term Capital Gains are known as gains made over a period of three years or more (LTCG). Investors can supplement their income using STCG from debt ETFs. STCG from debt funds is subject to a set 20% after-inflation tax.
- You can complement your wage with borrowed funds as an additional source of income. In addition, new investors might put a portion of their money into debt funds for liquidity. To obtain a pension, retirees might invest the majority of their retirement benefits in a debt fund.
Conclusion
You will have to choose the perfect debt fund according to your financial goals. Each debt fund has different features and benefits to offer to you – choose them wisely.
