A well-balanced mix of debt and equity in your portfolio is the secret to wealth generation from the market over time. Investors tend to focus primarily on equity, and in the quest, the debt component – that lends a sense of stability – is often overlooked. You should apportion a fair share of capital to debt investments at least as a risk management measure, even if your profile indicates you being an aggressive investor. Debt funds are one such financial instrument that cover you against market volatility coupled with steady low-risk returns while maintaining the liquidity of your investment.

This article covers: 

What are debt funds? 

Equity-oriented mutual funds are often criticized for their high-risk incidence. The need for a mutual fund with limited risk exposure gave rise to a class of mutual funds known as ‘debt funds.’ The core holdings of debt funds are invested in fixed-income securities; they have nothing to do with the fluctuations of the equity markets. Debt mutual funds are thus known to provide a steady income while maintaining a low-risk profile. 

Debt funds invest in a wide variety of fixed income-generating securities with variable maturity periods ranging from government bonds, treasury bills, short-term plans (STP), fixed maturity plans (FMP), gilt funds, monthly income plans (MIPs), and liquid funds. 

Types of debt funds

Debt funds are further subdivided into various types based on the tenor of the underlying securities held in the portfolio, and/or on the basis of the issuers of the securities (mostly government organizations) or at the discretion of the mutual fund house based on the fund management strategies.

Some of the most popular types of debt funds are as below:

  • Based on the investment horizon: short-term funds, medium-term funds, long-term funds
  • Based on the underlying asset: gilt funds, treasury funds, corporate bond funds, infrastructure debt funds
  • Based on the variability of returns: floating rate funds, dynamic bond funds, fixed maturity plans

How do debt funds work?

Debt funds pool investor capital and the fund managers invest it in carefully picked out debt securities such as corporate and government bonds, corporate debt securities, and money market instruments that offer capital appreciation. Credit ratings become an important measure of the risk involved in debt instruments, and that is one of the main roles of debt fund managers – to assess the credit risk and make the right pick of underlying assets for the funds. As the underlying fixed income asset generates interest, the value of the fund goes up. The returns are predictable but not fixed; returns are prone to milder fluctuations caused by interest rate changes.

Who should invest in debt funds? 

Debt funds are suitable for investors with a conservative approach and are looking for stable returns on their capital without exposing it to considerable risks. Investors with a moderate risk appetite can also consider investing in debt funds. While aggressive investors may find the risk-reward ratio of debt funds to be too low to their linking, debt funds may provide a ‘safety net’ for a part of your capital while you take a high risk with the remainder. Another case for investing in debt funds is to diversify your ‘all equity’ portfolio. Adding debt to your portfolio consisting of only equity is always a wise option.

Boxes to tick while investing in debt funds

There are tons of debt mutual funds offered by several asset management companies to choose from. The process can be confusing, especially when you don’t know how to draw a line of distinction between the options. Do consider the following aspects before investing in a debt mutual fund:

  • Investor profile: In their early days, investors may allocate a small portion of their corpus to offset the risks involved instead of going with all equity. In contrast, retired people could consider investing a significant portion of their income in debt funds for a safe avenue for capital appreciation.
  • Time frame: You need to decide the period for which you are willing to park your funds because that would significantly impact the choice of funds. If you aim to invest for shorter terms of around 3 mth to 1 yr, then liquid funds could possibly be a better choice for you. Those looking to stay invested for about 1-3 yrs can opt for short-term debt funds. In contrast, those with long-term objectives of 3-5 yrs can pick any of the best performing dynamic and medium-term bond funds. 
  • Risk incidence: Debt funds are often exposed to credit risk and interest rate risk, and it is vital to look into the history of the fund in mitigating these risks. However, interest rate risk is inherent and dependent on the government mechanism during the quarterly review of interest rates.
  • Cost: Debt funds generally have a low cost structure, however, they do have an expense ratio – towards management and administration of the fund. However, SEBI has fixed an upper limit of 2.25% to it. Nonetheless, it is prudent for investors to assess the impact of the costs on returns before investing in debt funds. Short-term debt funds have nil or negligible exit load – a kind of penalty levied towards withdrawal of funds before a minimum tenure of investment – investors may want to look into this component of charges too before considering investing in debt funds. 

Understanding taxation on gains from debt funds

An investor can realize two types of gains from debt funds. A short-term capital gain is realized when units of debt funds are liquidated within 36 mth of investment. Long-term capital gains are realized when the asset is sold after 36 mth.

Short-term capital gains (STCG) arising from debt funds are clubbed to the individual’s taxable income and are taxed according to the tax slab the individual falls in.

Long-term capital gains (LTCG) are taxed flat @ 20% after taking indexation benefits and have nothing to do with the tax slabs. 

A 4% cess is also added to the total tax, and the surcharge is applicable as well.

Long term capital gains (LTCG) are taxed at 20% flat after taking indexation benefits and have nothing to do with the tax slabs Click To Tweet

Perks of investing in debt funds

High liquidity 

The greatest advantage of debt mutual funds is that unlike fixed deposits and other fixed income investments, debt funds don’t have any lock-in period. You can liquidate your debt funds on any given day when you wish to or need funds. While debt funds may levy a small exit load towards early withdrawal, there are no penalties or charges on redemption of the funds. 

Flexibility and diversification

When you invest in fixed income products, you are getting just one instrument. Debt funds offer an opportunity for diversification within the debt universe. Also, debt funds enable you to transfer your funds to other funds. Using a Systematic Transfer Plan (STP), you can transfer your funds to equity funds or other kinds. This will evenly spread the risk that otherwise would have been concentrated only in one investment or a fund. 

Portfolio stability

Debt funds add the much-required debt component to your portfolio. Adding debt to your portfolio balances the risk exposure of the portfolio and cushions any downsides occurring in it from the volatile equity exposure. 

Higher returns

Debt funds have constantly yielded higher returns than conventional investment avenues like fixed deposits and saving bank accounts. 

Debt mutual funds don't have a lock-in period. You can liquidate these funds on any given day when you need funds or simply wish to Click To Tweet

Best performing debt funds in 2021

As on 4th Aug 2021, these were the 10 best-performing debt funds in India. This list is prepared based on the average 5-yr CAGR yielded by the funds. Please note that this list is liable to change as and when the fund composition changes or interest rates change.

S. No.Funds5-yr average CAGR
1ICICI Prudential Savings Fund7.5%
2ICICI Prudential Savings Fund Retail Plan7.2%
3SBI Magnum Ultra Short Duration Fund6. 6%
4Kotak Savings Fund6.6%
5Axis Liquid Fund6%
6Aditya Birla Sun Life Liquid6%
7Tata Liquid Fund6%
8Nippon India Liquid Fund6%
9Aditya Birla Sun Life Liquid Fund Institutional6%
10Tata Liquid Fund6%

Source

Disclaimer: This is not a recommendation. The sole purpose of providing this information is to educate you. Select funds based on your risk appetite, financial goals, and time factor, after careful research and analysis. 

Conclusion 

Debt funds may be considered a suitable investment avenue for investors to achieve stability in returns and capital appreciation over time while exposing their investments to a lower degree of risk. Investors may leverage the unique proposition of debt funds of investing in a wide array of fixed income instruments through a single investment and the fact that it has no lock-in period, providing investors with liquidity. Make sure to speak with your financial advisor before making any investments.

Atif Ahmed

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