What are Debt Funds? How it Works? & Its Types? 2023

Debt funds have become increasingly popular among investors who seek stable returns with relatively lower risk. These funds invest in fixed-income securities such as bonds, debentures, and other money market instruments that offer fixed returns.

Debt funds are managed by professional fund managers who aim to generate income for investors by investing in a diversified portfolio of debt securities. With the recent volatility in equity markets, many investors are turning to debt funds as a way to mitigate risk in their investment portfolio.

In this article, we will explore the basics of debt funds, their types, how they work, and the factors to consider before investing in them.

What are Debt Funds?

Debt funds are a type of mutual fund that invests in fixed-income securities such as bonds, government securities, treasury bills, corporate bonds, and money market instruments. These funds aim to provide investors with a steady stream of income while preserving their capital.

Debt funds are managed by professional fund managers who invest the money raised from investors in a diversified portfolio of debt securities. The fund managers focus on the credit quality, maturity, and yield of the securities while building the portfolio. The returns on debt funds depend on the interest rate movements and credit quality of the underlying securities.

Debt funds are considered to be less risky compared to equity funds, as they invest in fixed-income securities that provide a fixed rate of return. They are suitable for investors who seek a steady income stream, have a low-risk appetite, and want to diversify their investment portfolio. However, like any investment, debt funds carry some risk, and investors should carefully consider their investment objectives, risk tolerance, and financial situation before investing in them.

How does Debt Funds work?

Debt funds work by pooling money from several investors to invest in a portfolio of debt securities. The fund manager of the debt fund invests this pooled money in a diversified mix of debt instruments such as bonds, government securities, corporate debt, money market instruments, and other fixed-income securities.

The performance of the debt fund is linked to the performance of the underlying securities in its portfolio. The income generated from these securities, such as interest and coupon payments, is distributed among the investors in the form of regular dividends or interest income.

Debt funds are managed by professional fund managers who actively manage the portfolio by investing in securities that offer a balance between risk and return. The fund manager monitors the interest rate movements, credit quality of the underlying securities, and other market factors to make informed investment decisions.

The returns on debt funds are influenced by various factors such as interest rates, inflation, credit rating, and market volatility. Generally, debt funds are considered to be less risky than equity funds as they invest in fixed-income securities that offer a fixed rate of return.

Investors can invest in debt funds through various modes such as lump-sum investments or through systematic investment plans (SIPs). SIPs allow investors to invest a fixed amount at regular intervals, which helps in averaging out the cost of investment and mitigates the risks associated with market volatility.

In summary, debt funds provide investors with a low-risk investment option that generates regular income by investing in a diversified portfolio of fixed-income securities. The fund manager actively manages the portfolio to maximize returns while minimizing risk, making it a popular investment option for risk-averse investors.

Types of Debt Funds

Debt funds are mutual funds that invest in fixed-income securities such as government securities, corporate bonds, money market instruments, and other debt securities. These funds offer investors a relatively safe and stable investment option compared to equity funds, which carry a higher risk. Debt funds are categorized based on the duration of the underlying securities, the credit rating of the issuers, and other factors. Here’s a detailed explanation of all 18 types of debt funds:

1. Ultra-Short Duration Funds: These funds invest in debt securities with a maturity of up to 6 months, making them suitable for investors who want higher returns than a savings account but with lower risk than other debt funds.
2. Low Duration Funds: These funds invest in debt securities with a maturity of 6 to 12 months, offering a slightly higher risk-return profile than ultra-short duration funds.
3. Short Duration Funds: These funds invest in debt securities with a maturity of up to 3 years, offering a moderate risk-return profile and suitable for investors looking for a short to medium-term investment.
4. Medium Duration Funds: These funds invest in debt securities with a maturity of 3 to 4 years, offering a higher risk-return profile than short duration funds.
5. Long Duration Funds: These funds invest in debt securities with a maturity of more than 7 years, offering a high risk-return profile and suitable for investors with a long-term investment horizon.
6. Gilt Funds: These funds invest in government securities with varying maturities, offering a low-risk investment option for investors.
7. Corporate Bond Funds: These funds invest in bonds issued by companies, offering a relatively higher return than government securities but with moderate risk.
8. Credit Risk Funds: These funds invest in debt securities with lower credit ratings, offering higher returns than other debt funds but with higher risk.
9. Banking and PSU Funds: These funds invest in debt securities issued by banks and public sector undertakings, offering a low-risk investment option with higher returns than government securities.
10. Floating Rate Funds: These funds invest in debt securities with floating interest rates, offering protection against rising interest rates and suitable for investors with a short-term investment horizon.
11. Dynamic Bond Funds: These funds invest in a mix of debt securities with varying maturities, allowing the fund manager to adjust the portfolio based on changing market conditions.
12. Fixed Maturity Plans (FMPs): These funds invest in debt securities with a fixed maturity date, making them suitable for investors looking for a fixed return with a specific investment horizon.
13. Money Market Funds: These funds invest in short-term debt securities with a maturity of up to 1 year, offering a low-risk investment option with high liquidity.
14. Overnight Funds: These funds invest in debt securities with a maturity of 1 day, offering the lowest risk and highest liquidity among all debt funds.
15. Hybrid Debt Funds: These funds invest in a mix of debt and equity securities, offering a balanced investment option with exposure to both asset classes.
16. Interval Funds: These funds offer liquidity to investors only at specific intervals, typically ranging from a few months to a few years, making them suitable for investors with a longer investment horizon.
17. Debt Capital Protection Oriented Schemes (CPOS): These funds invest in a mix of debt securities and derivatives, with the objective of protecting the principal amount invested while generating returns.
18. Equity Savings Funds: These funds invest in a mix of equity, debt, and arbitrage opportunities, offering a tax-efficient investment option for investors with a medium to long-term investment horizon.

Benefits of investing in Debt Funds

Here are some benefits of investing in debt funds:

1. Low risk: Debt funds invest in fixed-income securities, which are relatively low-risk compared to equity funds. The risk of capital loss is lower in debt funds as they invest in highly rated bonds with a fixed maturity date.
2. Regular income: Debt funds provide regular income to investors in the form of interest payments or dividends. This makes them suitable for investors who want a regular stream of income.
3. Liquidity: Debt funds offer high liquidity as investors can buy and sell units of the fund on any business day. This makes it easy for investors to exit the investment in case of any emergency or need for funds.
4. Diversification: Debt funds offer a diversified portfolio of securities, which helps reduce risk and increase returns. Investors can benefit from the expertise of the fund manager in selecting the best investment opportunities.
5. Tax efficiency: Debt funds are tax-efficient compared to other investment options like fixed deposits. Long-term capital gains from debt funds are taxed at a lower rate than other investments.
6. Easy accessibility: Debt funds are easily accessible as they can be bought and sold through online platforms or a mutual fund distributor. The investment process is simple and convenient for retail investors.
7. Customization: Debt funds offer a range of options for investors with varying investment horizons and risk profiles. Investors can choose the type of debt fund that best suits their investment needs and goals.

Investing in debt funds can provide investors with a low-risk investment option that generates regular income, offers high liquidity, and is easily accessible. However, investors should conduct proper due diligence and consult with a financial advisor to determine whether debt funds align with their investment goals and risk tolerance.

Drawbacks of investing in Debt Funds

While there are several benefits to investing in debt funds, there are also some drawbacks that investors should be aware of:

1. Lower returns: Debt funds offer lower returns compared to equity funds. While they provide a steady stream of income, the returns may not be sufficient for investors seeking higher returns.
2. Interest rate risk: Debt funds are sensitive to changes in interest rates. If interest rates rise, the value of the fund may decrease, resulting in a capital loss for the investor.
3. Credit risk: Debt funds are subject to credit risk, which is the risk of default by the issuer of the debt security. If the issuer defaults on the security, the value of the fund may decrease, resulting in a capital loss for the investor.
4. Inflation risk: Debt funds may not provide sufficient returns to keep pace with inflation, resulting in a decrease in the purchasing power of the investor’s money.
5. Market risk: Debt funds are subject to market risk, which is the risk of fluctuations in the market. If the market experiences a downturn, the value of the fund may decrease, resulting in a capital loss for the investor.
6. Expense ratio: Debt funds have an expense ratio, which is the fee charged by the fund manager for managing the fund. This fee can reduce the investor’s returns over time.
7. Lack of transparency: Debt funds invest in a portfolio of debt securities, which can make it difficult for investors to understand the underlying investments and the level of risk associated with the fund.

It is important for investors to carefully evaluate the risks and benefits of investing in debt funds before making a decision. Investors should also conduct proper due diligence and consult with a financial advisor to determine whether debt funds align with their investment goals and risk tolerance.

Things to consider while investing in Debt Funds

Here are some important factors to consider while investing in debt funds:

1. Investment objective: Investors should first determine their investment objective, which could be capital preservation, regular income, or growth. This will help them choose the right debt fund that aligns with their investment goals.
2. Risk tolerance: Debt funds offer varying levels of risk, depending on the type of fund. Investors should evaluate their risk tolerance and choose a debt fund that matches their risk profile.
3. Investment horizon: The investment horizon is the duration for which the investor plans to hold the debt fund. Some debt funds are suitable for short-term investments, while others are better suited for long-term investments. Investors should choose a debt fund that matches their investment horizon.
4. Fund performance: Investors should evaluate the past performance of the debt fund before investing. This can be done by looking at the historical returns of the fund and comparing them to the benchmark index.
5. Expense ratio: Debt funds have an expense ratio, which is the fee charged by the fund manager for managing the fund. Investors should compare the expense ratio of different debt funds and choose a fund with a lower expense ratio.
6. Credit quality: Debt funds invest in a portfolio of debt securities with varying credit ratings. Investors should evaluate the credit quality of the debt securities in the portfolio and choose a debt fund that invests in high-quality debt securities.
7. Interest rate sensitivity: Debt funds are sensitive to changes in interest rates. Investors should evaluate the interest rate sensitivity of the debt fund and choose a fund that matches their interest rate view.
8. Fund manager: The fund manager plays a crucial role in the performance of the debt fund. Investors should evaluate the experience and track record of the fund manager before investing.
9. Tax implications: Investors should evaluate the tax implications of investing in debt funds. The tax treatment of debt funds varies based on the holding period and the type of fund.

Investors should conduct proper due diligence and consult with a financial advisor before investing in debt funds. By considering these factors, investors can make an informed decision and choose the right debt fund that aligns with their investment goals and risk profile.

Who should invest in Debt Funds?

Debt funds are suitable for investors who are looking for a relatively low-risk investment option that generates regular income. Debt funds are less volatile than equity funds and are less likely to be impacted by market fluctuations. Here are some types of investors who may consider investing in debt funds:

1. Conservative investors: Debt funds are suitable for conservative investors who are looking to preserve their capital and generate regular income.
2. Investors with a short investment horizon: Debt funds are suitable for investors who have a short investment horizon and are looking to invest for a period of 1-3 years.
3. Retirees: Debt funds are suitable for retirees who are looking for a steady stream of income to supplement their retirement income.
4. First-time investors: Debt funds are suitable for first-time investors who are new to investing and want to start with a relatively low-risk investment option.
5. Investors who want to diversify their portfolio: Debt funds are suitable for investors who want to diversify their portfolio and reduce their overall portfolio risk.

It is important to note that while debt funds are generally considered to be a low-risk investment option, they are not risk-free. Investors should conduct proper due diligence and consult with a financial advisor before investing in debt funds. By evaluating their investment objectives, risk tolerance, and investment horizon, investors can make an informed decision and choose the right debt fund that aligns with their investment goals.

Taxation of Debt Funds?

The taxation of debt funds in India is based on the holding period of the investment and the type of debt fund. Here is a brief overview of the taxation of debt funds:

1. Short-term capital gains tax: If an investor holds a debt fund for less than 3 years, any gains from the sale of the investment are considered short-term capital gains (STCG) and are taxed at the investor’s income tax slab rate.
2. Long-term capital gains tax: If an investor holds a debt fund for more than 3 years, any gains from the sale of the investment are considered long-term capital gains (LTCG). For debt funds, the LTCG tax rate is 20% with indexation benefit. Indexation helps adjust the purchase price for inflation and reduces the capital gains tax liability.
3. Dividend distribution tax: Debt funds may distribute dividends to their investors. The dividend distribution tax (DDT) is currently 28.84% (including surcharge and cess) for individuals, and 34.94% (including surcharge and cess) for corporates. However, effective from April 1, 2020, dividend income is taxable in the hands of the investors as per their income tax slab rate.
4. TDS (Tax Deduction at Source): TDS is applicable on interest income received from debt funds. The TDS rate is 10% if the investor’s PAN is available. If the investor’s PAN is not available, the TDS rate is 20%.
5. Capital gains statement: Debt fund investors are required to provide details of their capital gains in their income tax returns. The capital gains statement is provided by the fund house or the registrar.

It is important for investors to consult with a tax expert to understand the tax implications of investing in debt funds. By understanding the tax treatment of debt funds, investors can make an informed decision and maximize their returns.

How to choose Debt Funds?

Choosing the right debt fund can be a crucial decision that can impact your investment returns. Here are some factors to consider when choosing a debt fund:

1. Investment objective: Debt funds have different investment objectives, such as generating regular income or capital appreciation. Choose a debt fund that aligns with your investment objective.
2. Credit quality: Debt funds invest in securities with different credit ratings. A higher credit rating indicates a lower risk of default. Choose a debt fund with an appropriate credit quality based on your risk appetite.
3. Interest rate sensitivity: Debt funds are impacted by changes in interest rates. Longer duration debt funds are more sensitive to interest rate changes, while short-term debt funds are less sensitive. Choose a debt fund based on your investment horizon and interest rate outlook.
4. Fund manager track record: The fund manager’s experience and track record can give an indication of the fund’s performance. Look for a fund manager with a proven track record of managing debt funds.
5. Expense ratio: The expense ratio is the fee charged by the fund house to manage the fund. A lower expense ratio can result in higher returns. Choose a debt fund with a low expense ratio.
6. Asset size: The size of the fund can impact its performance. A very small fund may not have the scale to diversify its portfolio, while a very large fund may find it challenging to invest in securities with limited liquidity. Look for a debt fund with an appropriate asset size.
7. Exit load: An exit load is a fee charged by the fund house if the investor exits the fund before a specified period. Choose a debt fund with an appropriate exit load based on your investment horizon.
8. Risk-adjusted returns: Evaluate a debt fund’s performance based on its risk-adjusted returns. The Sharpe ratio can provide a measure of a fund’s risk-adjusted returns.

It is important to remember that past performance is not a guarantee of future returns. Investors should conduct proper due diligence and consult with a financial advisor before investing in debt funds. By evaluating the factors mentioned above, investors can make an informed decision and choose the right debt fund that aligns with their investment goals.