In this article we will look at one major category of mutual funds – Debt Mutual Funds.
We will understand the meaning of debt mutual funds, how they are managed, what kind of investors they are suitable as well as its advantages and risks.
Mutual funds are an investment avenue that allows you to access investments in a variety of asset classes and securities by a single mutual fund investment.
A mutual fund pools in resources from several investors and reinvents those across securities.
About Debt Mutual Fund
Debt mutual funds are mutual funds that invest most of its corpus in debt securities. Debt securities are fixed income securities that generate regular income for its investors.
Examples of debt securities include government bonds, corporate bonds, money market instruments etc. These securities have a pre-determined coupon rate, maturity date and maturity price.
Purchasing a debt security is akin to giving a loan to the government or corporate entity, in exchange for interest payments.
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How are Debt Mutual Funds managed?
Like all other mutual funds, experienced fund managers manage debt mutual funds.
These fund managers seek out suitable debt securities in line with the objectives of the specific debt funds that they are managing.
Fund managers rely heavily on credit ratings in evaluation of various debt securities.
Every economy has authorized credit rating agencies. These agencies evaluate the financial and other credentials of a company to gauge its credit worthiness.
Based on their evaluation they issue a credit rating to the company as well as to its issued debt instruments.
Debt fund managers look towards these ratings while selecting the mix of debt securities for its portfolio.
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Typically, higher rated debt securities offer lower coupon rates than lower rated debt securities.
On the other hand, higher rated debt securities are considered safer and less risky than lower rated securities.
Thus, evaluation of credit rating of debt securities is essentially an evaluation of a risk-return trade-off.
Debt mutual funds can cater to different time horizons. This is based on the maturity duration of the debt securities that they invest in.
In times of rising interest rates, fund managers prefer securities of short-term maturities.
This is so that they can redeem the investments and re-invest in higher interest-bearing securities as the market interest rates rise.
On the other hand, in times of falling interest rates, fund managers opt for securities of long-term maturities to lock in higher rates before market interest rates fall.
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Who should Invest in Debt Mutual Funds?
Debt mutual funds are considered lower risk as compared to equity and hybrid funds. This is essentially because they have a pre-determined interest rate which is not dependent on market fund.
There are thus suitable for the following type of investors:
- Low risk investors
- Investors with short term investing horizon
- Those looking for regular, fixed return on their investments
- Yet looking to earn returns higher than traditional bank savings or fixed deposits
- Investors looking to fund their critical life goals which require low risk investments
Type of Debt Funds
There are a wide variety of debt mutual funds available for investors to choose from depending on their investing objective and time horizon. These include:
Short Duration Funds
These funds invest in debt securities of short-term duration of one to three years.
The risk of such funds is very low as owing to their short term they are less susceptible to fluctuations in interest rates and their impact on value of the fund’s investments.
Medium Duration Funds
The duration of the debt securities within these funds range from 3 to 5 years
Long Duration Funds
The duration of the debt securities within these funds are for a minimum of 5 years or more.
These funds invest in highly liquid money market instruments. Such instruments typically have maturities of up to 91 days, making them extremely low risk.
These funds are meant for investors who want to temporarily park their funds, looking for high liquidity but want returns higher than conventional savings banks.
These funds invest in government securities. As government securities are sovereign in nature, they carry practically no default risk.
Investors in gilt funds thus get the benefit of stable income with practically no risk.
Dynamic Bond Funds
These funds have an active management strategy. Fund managers of these funds continuously alter the investment portfolio to take advantage of fluctuating interest rates.
The funds consist of debt securities of both short and long maturities, depending on interest rate opportunities that arise.
Fixed Maturity Plans
These come with a lock-in period. They invest in high rated bonds of the government as well as of high rated corporates.
The intention is to provide its investors with fixed income over a defined fixed time.
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Benefits of Investing in Debt Mutual Funds
Investing in debt mutual funds offer several advantages such as:
Debt mutual funds invest in fixed income securities. These securities provide regular income at pre-determined interest rates and at pre-determined time intervals.
This ensures regular and stable returns for investors of this funds
The return from these mutual funds is not dependent on market fluctuations. Their investments earn fixed and regular income.
This makes it subject to significantly lower risk than equity and hybrid mutual funds.
An investor can reduce the overall risk profile of his portfolio through investment in these mutual funds.
Tax Related Benefits
Investments in debt mutual funds are more tax efficient than traditional saving instruments such as fixed deposits.
Interest on fixed deposits is subject to tax deducted at source as well are taxable year on year in the hands of the investor.
On the other hand, income from this funds is not taxed year on year but only on redemption as capital gains.
They are also not subject to TDS. In case these mutual funds are held for a long term, they also get indexation benefit while computing tax on capital gains.
Investors can redeem their investments in debt mutual funds at any time. In fact, the redemption process today is streamlined and takes place online.
Investors receive the credit of the redemption proceeds within a day or two.
This makes investments in it extremely liquid. This is the case especially when compared to fixed deposits that incur penal charges for pre-mature cancellation.
There are various modes of investing in debt mutual funds. One of these modes is Systematic Transfer Plans (STP). In these plans, investors make lumpsum investments in these funds.
They can then systematically withdraw and transfer their investments to more lucrative equity funds.
The transfer takes place at regular, pre-determined intervals. In this way such mutual funds offer significant flexibility to its investors.
Risks associated with Debt Mutual Funds
While these mutual funds have several advantages, investors must also be aware of the risks that they carry.
Though debt funds have much lower risk as compared to equity funds, they are not entirely free from risk.
They are subject to certain type of risks associated with their principal repayment and interest servicing. These include:
This is a risk that the issuer of debt securities with default in either the interest obligations or principal repayment or both.
Interest rate risk
This is the risk that value of debt securities of the mutual fund is dependent on fluctuating interest rates.
This is the risk that the asset management company of the mutual fund may not have sufficient liquidity to meet the requests for redemptions of the investors.
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Taxation on Debt Mutual Funds
Investments in debt mutual funds are taxable in nature. Investors can redeem part or whole of their investments. The resultant gains or losses are taxed as capital gains.
If the investment is held for less than 3 years, it is termed as short term from a tax perspective. If it is held for more than 3 years it becomes long term from the taxation perspective.
Short term capital gains are taxed at the tax rate applicable to the investor depending on the tax slab that they fall in.
Long term capital gains are taxed at 20% after indexation benefit. They are not subject to TDS.
Ways to Invest in Debt Mutual Funds
Fund houses several modes of investing in debt mutual funds:
Lumpsum – Investing in the mutual fund through a single payment
Systematic Investment Plan or SIP – Investing in the fund through instalments at regular time intervals.
STP or Systematic Transfer Plan – Investing in one type of fund via a lumpsum and regularly transferring a pre-determined amount from this fund to another fund of the investor’s choice.
Systematic Withdrawal Plan or SWP – This mode of investing in these mutual funds allows investors to opt for pay-outs at regular intervals.
These pay-outs can be monthly, quarterly, or annually.
Debt Mutual Funds – Conclusion
All in all, if you are a relatively risk-averse investor looking for stable returns, then debt mutual funds are suitable for you.
You can choose the type of these mutual fund based on the duration of the investment that you wish to make.
You can also choose debt funds to bring stability and balance to your investment portfolio that has other high-risk investments.
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