What is a Debt Fund? – Meaning, Types & How to Invest

What is a Debt Fund

Debt Funds are a category of Mutual Fund that invests in securities that bear fixed interest income and are, relatively, less risky. Let us get into detail to understand these funds a little better. These kinds of Mutual Funds are for those investors who are risk-averse in nature. Debt Funds carry a portfolio of securities like Corporate Bonds, Treasury Bills, Commercial Papers, and Government Securities. These are called fixed-income securities because they provide a fixed rate of interest which is, generally, paid annually. These securities are less-risky in nature as they are backed by the Government or are secured by mortgages.

How do Debt Funds Work

When an investor invests his money in Debt Funds, the fund, further, invests that money in a portfolio of different fixed income securities. Income is earned in the form of interest by the Debt Funds which is, in turn, passed on to the investors. The Debt Funds work in a manner similar to Fixed Deposits (commonly, called ‘FDs’) made with banks.

When money is invested in a Fixed Deposit, the bank reinvests that money in the form of loans to corporates and individuals to earn a percentage of return that is higher than the interest paid to FD holders.

Debt Funds also earn through capital appreciation on their investment. Debt securities have a separate market of their own and are as such not affected by the equity market’s volatility. However, Debt Funds are sensitive to changes in the interest rate in the economy. For instance, if the interest rate on borrowings is lowered by the Reserve Bank of India, the bonds and other fixed-interest securities that are issued subsequently offer the lower rate of interest. This makes the securities issued earlier more attractive for the investors since they carry a higher coupon rate. This, in turn, leads to an increase in their market prices. Thus, Debt Funds holding securities with higher coupon rates see appreciation in their market value, which, in turn, gives capital gains to the investors on their units held in Debt Funds.

Types of Debt Funds

Based on the types of debt instruments invested in and their maturity period, Debt Funds can be categorized as follows:

On the Basis of Maturity

• Overnight Funds: These funds park the money of investors in securities having overnight maturity. They have high liquidity. The securities purchased on day 1 are sold the next day to earn from value appreciation. Thus, these are considered extremely safe since both credit risk and interest rate risk are negligible.

• Liquid Funds: As the name suggests, these funds invest in securities with a very short tenure of not more than 91 days, thus, providing liquidity. These securities are, generally, money market instruments like treasury bills and commercial paper which are issued for short-term financing. Return is generally low along with lower risk.

• Ultra-Short Duration Funds: These funds invest in instruments and debt securities with maturities varying between three to six months. While liquid funds, primarily, invest in money-market instruments having maturity within 91 days, these funds invest in securities whose maturity is generally more than 91 days.

• Low Duration Funds: These funds invest in short-term debt securities with maturity usually in the range of six to twelve months. These are, particularly, popular among retail and institutional investors who wish to borrow money for about a year.

• Money Market Fund: These funds invest in money market instruments having a maturity of upto one year. They are suitable for investors looking to fulfill short-term financial goals.

• Short Duration Funds: These funds invest in securities having maturity ranges between one to three years. These funds offer stable returns with moderate risk and are ideal for investors looking to invest their money for a short period of time.

• Medium Duration Funds: These funds invest in short-term debt securities with maturity in the range of three to four years. Such funds prove to be a good alternative for fixed deposits since they are capable of giving higher returns within the same maturity bracket.

• Medium to Long Duration Funds: These funds invest in long-term debt securities with maturity in the range of four to seven years. Such funds can be preferred by investors looking for a longer-term investment. However, the risk may be high as compared to other debt funds.

• Long Duration Funds: These funds invest in debt securities with a maturity of more than seven years. These carry a higher risk of default, but the capital gains can also be higher. Such funds can be ideal for investors looking to park their money for a very long period of time.

• Dynamic Bonds Funds: These funds invest in debt securities across different maturity profiles based on the interest rate changes and their expectations by fund managers. These types of funds give the fund managers flexibility to invest in both short-term and long-term instruments so that they can take advantage of the changes in interest rate. This helps in effective interest rate risk mitigation as well since short-term changes in interest rate are covered by long-term interest stability.

On the Basis of Types of Securities Invested in

• Corporate Bonds Fund: These funds invest at least 80% of their corpus in companies that carry a high credit rating (usually, AA and above). Since they invest in the highest-rated corporate entities, it is better suited for investors looking for safer investment opportunities and moderate returns.

• Credit Risk Funds: These funds invest at least 65% of their corpus in companies that carry a high credit rating (usually, AA and below). Due to the lower credit rating of the debt instruments in these funds the risk is higher than Corporate Bond Funds.

• Banking & PSU Funds: These funds invest 80% of its investible corpus in debt securities of Public Sector Undertakings (PSUs) and public/ private sector banks. These are, again, less risky as they are backed by the government and are highly regulated sectors. The returns can be from low to moderate.

• Gilt Funds: These funds invest 80% in Government securities of varying tenures. Since the issuer is the government, these funds are extremely safe which makes them an ideal choice for risk averse investors looking for fixed returns.

• Gilt Funds with 10-year constant duration: Gilt Fund with 10-Year Constant Duration invests in government bonds. These bonds are issued by the RBI to investment houses when they disburse funds to the government be it state or central. Gilt funds, according to SEBI norms, must have at least 80% of the total assets invested in government securities. They generally have a fixed Macaulay duration of 10-Years. 

• Floater Funds: Certain types of bonds have a floating interest rate. This would mean that the interest rate is not pre-decided and the changes depend upon their benchmark. A fund that has more than 65% of its total assets invested in such bonds is defined as a floating rate Debt Fund or a Floater Fund. Instruments in Floater Funds can be corporate bonds or even loans from corporates that have a variable floating interest rate. 

Who Should Invest in Debt Funds

Debt Funds provide the benefit of liquidity over other funds. These can be a better choice of investment over fixed deposits since the interest rate offered is higher. In comparison to equity, these are much safer to invest in since the debt market is comparatively less volatile. However, the return offered to investors is fixed and returns from capital appreciation tend to be lower as compared to equity.

Thus, Debt Funds can be ideal for investors who desire decent returns, are risk-averse and in some cases also require regular income. The investors are not required to monitor the changes in the market since these are stable investments that are managed by professional fund managers.

Also, investment in these types of funds allows investors to earn better returns as compared to traditional fixed income products such as Bank Fixed Deposits.

Things to consider as an investor

• Return: Returns on Debt Funds are lower as compared to equity funds. The returns are better when the investments are for a longer period. Further, Debt Funds perform well when the interest rates are falling. 

• Risk: Debt Funds are exposed to credit and interest rate risks. Credit risk arises when the issuer defaults in redeeming the units of the bondholders. Interest rate risk arises when a change in interest rate adversely affects the price of the bond. This is particularly true for securities that are not backed by the government or mortgages. The investor should look for the credit rating of debt instruments included in the funds before proceeding.

• Cost: The Debt Fund charges operating fees as a percentage of the total assets which is called the expense ratio. Since the return is already low in the case of Debt Funds, investors should choose funds that charge a low expense ratio so that returns are maximized. Also, the cost of maintenance should be low in these funds since they do not require a dedicated team to monitor the changes in the market.

• Macaulay Duration: Macaulay Duration shows the average time period that the bond needs to generate the cash flows in so that the initial investment in the fund equals the price at maturity at a given rate of interest. So, if the Macaulay Duration for a bond is 3 years, it means that it will take the bond 3 years to generate the cash flows (interest and capital appreciation) to repay the investment made in it, given the inflation rate. So, the investors should check whether the Macaulay duration of the fund equals their investment horizon.

• Asset allocation and maturity period: It is the asset allocation that determines how much a fund is affected by changes in interest rates. If the fund has invested in more ultra-short duration or low duration funds, it is likely to be less volatile but yield less return. If they have invested more in medium to long term or long-term duration funds, it is likely to be more volatile, but also yield better returns. 

Tax on Debt Mutual Funds

Capital Gains

When the investor sells his investment in a Debt Fund, the transaction attracts tax in the form of capital gains. Capital gain is appreciation in the value of the security on the selling date as compared to the price on purchasing date. The period for which the investment is held becomes important in this regard since it determines whether the gain will be long or short term, which attracts different rates of tax.

If the investment is held for a period of fewer than three years, the gain on such investment will be subject to short-term capital gain tax (STCG). Such STCG is charged to tax as per the investor’s income tax slab rate. If the units of the scheme are held for more than three years, then the investment would be subject to long-term capital gains tax (LTCG). LTCG is taxed at 20% with indexation benefits.

Interest Income

The interest on Debt Funds is also subject to tax as per the normal slab rate. Some funds might offer tax-exempt interest income as well. This will vary for different funds.

How to Invest in Debt Funds with Nivesh

Any investor can enjoy the benefits of investing through Nivesh in the following easy steps:

• Create an account in Nivesh by providing your basic KYC details. (If you already have an account then just login into your account)
• On your portfolio page click on the Buy New tab at the right top corner of the screen.
• Select the category and choose the funds you want to purchase.
• If you already know the name of the fund to buy, then you can search the particular fund through Quick Order.
• Fill the transaction details and confirm. You can place up to 5 orders in one go.
• You can make payment through your registered account through UPI, Direct Pay, or NEFT/ RTGS , Bank Mandate or Cheque. For same-day NAV, select UPI, Direct Pay or NEFT / RTGS as other payment options may take a few days to clear, Nodal account takes about 1-2 days to clear payment from the approved mandate and cheque takes about 2-5 days in clearing due to which you will not get the same-day NAV.

Frequently Asked Questions (FAQs)

1. How do Debt Funds work?

Debt Funds generate returns for investors by investing their money into instruments of the debt market and earning interest thereon. By earning interest on the investment, they are able to provide a return to the investors. Debt Funds also earn through capital appreciation on their investment.

2.  How to Choose Debt Funds?

The investors should first define their investment objective. If the objective is to park money for

the short term, then short-term debt funds should be preferred over other debt funds. Similarly, if the low risk is preferred, then government and short-duration bonds should be preferred.

3. Is a Debt Fund Taxable?

Yes, capital gain and interest income from Debt Funds are taxable. Depending on the period for which the units of the Debt Fund scheme are held, they are chargeable to tax as short-term capital gains (STCG) or long-term capital gains (LTCG). STCG (if held for less than 3 years) are taxed as per the applicable income tax rates while LTCG (if held for more than 3 years) are taxed at 20% after indexation benefits.