Debt Funds: Going Beyond Equity

Debt funds primarily invest in debt instruments issued by corporations and governments. But what are debt instruments?

Debt instruments are issued by governments and companies to raise funding for their operations and business. You can buy these instruments to earn returns and generate income from your savings.

In this article, we discuss debt funds and explore them from an investment perspective.

How do debt funds work?

Debt funds pool money from investors and invest in various types of debt instruments based on their investment objectives.

Each debt instrument has its own set of characteristics like interest rate, yield to maturity, maturity date, credit rating etc.

The primary objective of the fund manager of debt funds is to construct an optimised investment portfolio composed of debt instruments. The fund manager also has to ensure that the debt fund follows its mandate and strikes the right balance between risk and return.

Where do debt funds invest?

The allocation to different types of securities depends on the debt fund’s investment mandate and risk profile. Here are some prominent fixed-income securities that debt funds invest in:

●Government bonds: Issued by the central and state government to finance welfare and infra projects.

●Treasury bills: Issued by the central government to manage short-term cash flows

●Corporate bonds: Issued by companies for working capital or general business purposes

●PSU bonds: Issued by Public Sector Undertakings, have an implicit guarantee from the government.

Wealth management companies specialise in high-yield debt instruments and debt mutual funds to preserve their client’s wealth.

Types of debt funds

Currently, more than 1,500 debt funds across dozens of categories are available for investments in India.

Let’s look at the 6 most popular debt mutual fund categories.

1. Liquid funds: Low-risk mutual funds that invest in short-term debt securities with maturities of up to 91 days, offering high liquidity and stable returns.

2. Money market funds: Invests in short-term, low-risk instruments like treasury bills and commercial papers with a maturity of up to 1 year, providing safety and steady income to investors.

3. Gilt funds: Mutual funds that exclusively invest in government securities are considered relatively low-risk due to the government’s backing.

4. Corporate bond funds: Corporate bond funds invest primarily in the highest-rated (AAA) bonds issued by private and public companies.

5. Banking & PSU funds: These funds primarily invest in debt instruments issued by banks and public sector undertakings, combining safety with slightly higher returns than liquid funds.

6. Credit risk funds: Funds that invest in lower-rated debt securities, offering potentially higher returns but carrying a higher risk of default. Investors should be cautious due to the increased credit risk.

Should you invest in debt funds?

Investing in debt funds provides liquidity, stability, diversification, and the potential for regular income. The risk involved in debt funds is lower than equity or stocks, making them suitable for conservative investors.

These funds have the potential to offer better returns compared to bank fixed deposits (FDs). Additionally, investors seeking regular payouts, similar to the interest received in FDs, can opt for a systematic withdrawal plan (SWP) on the funds.

Risks associated with debt funds

Although debt funds are considered low-risk investments, they are not risk-free. Investors should consider the following risks before investing:

●Interest Rate Risk: Changes in interest rates can affect the value of fixed-income securities held by debt funds, leading to fluctuations in their net asset value (NAV).

●Credit Risk: Debt funds are exposed to the risk of default by the issuers of the underlying bonds in their portfolio.

Investing in bonds and mutual funds through expert-led investing platforms like Dezerv can help you minimise investing risks while improving your portfolio performance.

Tax implications in debt funds

Capital gains or profits from debt funds are of two types:

1. Short-term capital gains or STCG (for holding periods less than 3 years)

2. Long-term capital gains or LTCG (for  holding periods more than 3 years)

For investments made prior to 1 June 2023, STCG was taxed at your marginal income tax rate, whereas LTCG was taxed at a flat rate of 20% with the benefit of indexation.

Indexation refers to adjusting the value of gains to inflation, reducing the tax burden on investors.

However, for investments made after 1 June 2023, the LTCG and indexation benefit will not be applicable on the capital gains or profits from debt funds. Instead, all gains, irrespective of the holding period, will be taxed at your marginal income tax rate.

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